What are the bond markets telling us about inflation, recession and the path of central bank policy?

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Macro Letter – No 41 – 11-09-2015

What are the bond markets telling us about inflation, recession and the path of central bank policy?

  • Since January US Government bond yields have risen across the yield curve
  • Corporate bond yields have risen more rapidly as stock markets have retreated
  • China, Canada and Mexico have seen their currencies weaken against the US$

For several years some commentators have been concerned that the Federal Reserve is behind the curve and needs to tighten interest rates before inflation returns. To date, inflation – by which I refer narrowly to CPI – has remained subdued. The recent recovery in the US economy and improvement in the condition of the labour market has seen expectations of rate increases grow and bond market yields have risen in response. In this letter I want to examine whether the rise in yields is in expectation of a Fed rate increase, fears about the return of inflation or the potential onset of a recession for which the Federal Reserve and its acolytes around the globe are ill-equipped to manage.

Below is a table showing the change in yields since the beginning of February. Moody Baa rating is the lowest investment grade bond. Whilst the widening of spreads is consistent with the general increase in T-Bond yields, the yield on Baa bonds has risen by 30bp more than Moody BB – High Yield, sub-investment grade. This could be the beginning of an institutional reallocation of risk away from the corporate sector.

Bond       Spread over T-Bonds    
08-Sep 02-Feb Change 08-Sep 02-Feb Change
10yr US T-Bond 2.19 1.65 0.54 N/A N/A N/A
Baa Corporate 5.28 4.29 0.99 3.09 2.64 0.45
BB Corporate 5.55 4.86 0.69 3.36 3.21 0.15

 

Source: Ycharts and Investing.com

The chart below shows the evolution of Baa bond yields over the last two years:-

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

The increase in the cost of financing for the corporate sector is slight but the trend, especially since May, is clear.

Another measure of the state of the economy is the breakeven expected inflation rate. This metric is derived from the differential between 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities:-

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

By this measure inflation expectations are near their lowest levels since 2010. It looks as if the bond markets are doing the Federal Reserve’s work for it. Added to which the July minutes of the FOMC stated:-

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

This is hardly hiking rhetoric.

The International perspective

The table below looks at the largest importers into the US and their contribution to the US trade deficit as at December 2014:-

Country/Region Imports Deficit
China $467bln $343bln
EU $418bln $142bln
Canada $348bln $35bln
Mexico $294bln $54bln
Japan $134bln $68bln

Source: US Census Bureau

The TWI US$ Index shows a rather different picture to the US$ Index chart I posted last month, it has strengthened against its major trading partners steadily since it lows in July 2011; after a brief correction, during the first half of 2015, the trend has been re-established and shows no signs of abating:-

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

A closer inspection of the performance of the Loonie (CAD) and Peso (MXN) reveals an additional source of disinflation:-

CAD and MXN vs USD 2yr

Source: Yahoo Finance

Focus Economics – After dismal performance in May, exports and imports increase in June – investigates the bifurcated impact of lower oil prices and a weaker currency on the prospects for the Mexican economy:-

Looking at the headline numbers, exports increased 1.2% year-on-year in June, which pushed overseas sales to USD 33.8 billion. The monthly expansion contrasted the dismal 8.8% contraction registered in May. June’s expansion stemmed mainly from a solid increase in non-oil exports (+6.8% yoy). Conversely, oil exports registered another bleak plunge (-41.0% yoy).

Should the U.S. economy continue to recover and the Mexican peso weaken, growth in Mexico’s overseas sales is likely to continue improving in the coming months.

Mexico’s gains have to some extent been at the expense of Canada as this August 2015 article from the Fraser Institute – Canada faces increased competition in U.S. market – explains:-

There are several possible explanations of the cessation of real export growth to the U.S. One is the slow growth of the U.S. economy over much of the period from 2000-2014, particularly during and following the Great Recession of 2008. Slower real growth of U.S. incomes can be expected to reduce the growth of demand for all types of goods including imports from Canada.

A second possible explanation is the appreciation of the Canadian dollar over much of the time period. For example, the Canadian dollar increased from an all-time low value of US$.6179 on Jan. 21, 2002 to an all-time high value of US$1.1030 on Nov. 7, 2007. It then depreciated modestly to a value of US$.9414 by Jan. 1, 2014.

A third possible explanation is the higher costs to shippers (and ultimately to U.S. importers) associated with tighter border security procedures implemented by U.S. authorities after 9/11.

Perhaps a more troubling and longer-lasting explanation is Canada’s loss of U.S. market share to rival exporters. For example, Canada’s share of total U.S. imports of motor vehicles and parts decreased by almost 12 percentage points from 2000 through 2013, while Mexico’s share increased by eight percentage points. Canada lost market share (particularly to China) in electrical machinery and even in its traditionally strong wood and paper products sectors.

There is fundamentally only one robust way for Canadian exporters to reverse the recent trend of market share loss to rivals. Namely, Canadian manufacturers must improve upon their very disappointing productivity performance over the past few decades—both absolutely and relatively to producers in other countries. Labour productivity in Canada grew by only 1.4 per cent annually over the period 1980-2011. By contrast, it grew at a 2.2 per cent annual rate in the U.S. Even worse, multifactor productivity—basically a measure of technological change in an economy—did not grow at all over that period in Canada.

With an election due on 19th October, the Canadian election campaign is focused on the weakness of the domestic economy and measures to stimulate growth. While energy prices struggle to rise, non-energy exports are likely to be a policy priority. After rate cuts in January and July, the Bank of Canada left rates unchanged this week, but with an election looming this is hardly a surprise.

China, as I mentioned in my last post here, unpegged its currency last month. Official economic forecasts remain robust but, as economic consultants Fathom Consulting pointed out in this July article for Thomson Reuters – Alpha Now – China a tale of two economies – there are many signs of a slowing of economic activity, except in the data:-

With its usual efficiency, China’s National Bureau of Statistics released its 2015 Q2 growth estimate earlier this week. Reportedly, GDP rose by 7.0% in the four quarters to Q2. We remain sceptical about the accuracy of China’s GDP data, and the speed with which they are compiled. Our own measure of economic activity — the China Momentum Indicator — suggests the current pace of growth is nearer 3.0%.

…although policymakers are reluctant to admit that China has slowed dramatically, the recent onslaught of measures aimed at stimulating the economy surely hints at their discomfort. While these measures may temporarily alleviate the downward pressure, they do very little to resolve China’s long standing problems of excess capacity, non-performing loans and perennially weak household consumption.

Accordingly, as China tries out the full range of its policy levers, we believe that eventually it will resort to exchange rate depreciation. Its recent heavy-handed intervention in the domestic stock market has demonstrated afresh its disregard for financial reform.

The chart below is the Fathom Consulting – China Momentum Indicator – note the increasing divergence with official GDP data:-

Fathom_Consulting_China_Momentum_Indicator

Source: Fathom Consulting/Thomson Reuters

A comparison between international government bonds also provides support for those who argue Fed policy should remain on hold:-

Government Bonds 2yr 2yr Change 5yr 5yr Change 10yr 10yr Change 30yr 30yr Change
08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb
US 0.74 0.47 0.27 1.52 1.17 0.35 2.19 1.65 0.54 2.96 2.23 0.73
Canada 0.45 0.39 0.06 0.79 0.61 0.18 1.48 1.25 0.23 2.24 1.83 0.41
Mexico 5.01* 4.13* 0.88 5.29 4.89 0.4 6.15 5.41 0.74 6.81 6.1 0.71
Germany -0.22 -0.19 -0.03 0.05 -0.04 0.09 0.68 0.32 0.36 1.44 0.9 0.54
Japan 0.02 0.04 -0.02 0.07 0.09 -0.02 0.37 0.34 0.03 1.41 1.31 0.1
China 2.59 3.22 -0.63 3.2 3.45 -0.25 3.37 3.53 -0.16 3.88 4.04 -0.16

*Mexico 3yr Bonds

Source: Investing.com

Canada and Mexico have both witnessed rising yields as their currencies declined, whilst Germany (a surrogate for the EU) and Japan have seen a marginal fall in shorter maturities but an increase for maturities of 10 years or more. China, with a still slowing economy and aided by PBoC policy, has lower yields across all maturities. Mexican inflation – the highest of these trading partners – was last recorded at 2.59% whilst core inflation was 2.31%. The 2yr/10yr curve for both Mexico and Canada, at just over 100bps, is flatter than the US at 145bp. The Chinese curve is flatter still.

A final, if somewhat tangential, article which provides evidence of a lack of inflationary pressure comes from this fascinating post by Stephen Duneier of Bija Advisors – Doctoring Deflation – in which he looks at the crisis in healthcare and predicts that computer power will radically reduce costs globally:-

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Conclusions and investment opportunities

The bond yield curves of America’s main import partners have steepened in train with the US – Canada being an exception – whilst stock markets are unchanged or lower over the same period – February to September. Corporate bond spreads have widened, especially the bottom of the investment grade category. Corporate earnings have exceeded expectations, as they so often do – see this paper by Jim Liew et al of John Hopkins for more on this topic – but by a negligible margin.

The FOMC has already expressed concern about the momentum of GDP growth, commodity prices remain under pressure, China has unpegged and the US$ TWI has reached new highs. This suggests to me, that inflation is not a risk, disinflationary forces are growing – especially driven by the commodity sector. Major central banks are unlikely to tighten but corporate bond yields may rise further.

Currencies

Remain long US$ especially against resource based currencies, but be careful of current account surplus countries which may see flight to quality flows in the event of “risk off” panic.

Stocks

At the risk of stating what any “value” investor should always look for, seek out firms with strong cash-flow, low leverage, earnings growth and comfortable dividend cover. In addition, in the current environment, avoid commodity sensitive stocks, especially in oil, coal, iron and steel.

Bonds

US T-Bonds will benefit from a strengthening US$, if the FOMC delay tightening this will favour shorter maturities. An early FOMC tightening, after initial weakness, will be a catalyst for capital repatriation – US T-Bonds will fare better in this scenario too. Bunds and JGBs are likely to witness similar reactions but, longer term, both their currencies and yields are less attractive.

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An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?

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Macro Letter – No 40 – 28-08-2015

An Autumn Reassessment – Will the fallout from China favour equities, bonds or the US Dollar?

  • The FOMC rate increase may be delayed
  • An equity market correction is technically overdue
  • Long duration bonds offer defensive value
  • The US$ should out-perform after the “risk-off” phase has run its course

It had been a typical summer market until the past fortnight. Major markets had been range bound, pending the widely-anticipated rate increase from the FOMC and the prospect of similar, though less assured, action from the BoE. The ECB, of course, has been preoccupied with the next Greek bailout, whilst EU politicians wrestle with the life and death implications of the migrant crisis.

What seems to have changed market sentiment was the PBoC’s decision to engineer a 3% devaluation in the value of the RMB against the US$. This move acted as a catalyst for global markets, commentators seizing on the news as evidence that the Chinese administration has lost control of its rapidly slowing economy. As to what China should do next, opinion is divided between those who think any conciliatory gesture is a sign of weakness and those who believe the administration must act swiftly and with purpose, to avoid an inexorable and potentially catastrophic deterioration in economic conditions. The PBoC reduced interest rates again on Wednesday by 25bp – 1yr Lending Rate to 4.6% and 1yr Deposit Rate to 1.75% – they also reduced the Reserve Ratio requirement from 18.5% to 18%. This is not exactly dramatic but it leaves them with the flexibility to act again should the situation worsen.

Markets, especially equities, have become more volatile. The largest bond markets have rallied as equities have fallen. This is entirely normal; that the move has occurred during August, when liquidity is low, has, perhaps, conspired to exacerbate the move – technical traders will await confirmation when new lows are seen in equity markets during normal liquidity conditions.

Has anything changed in China?    

The Chinese economy has been rebalancing since 2012 – this article from Michael Pettis – Rebalancing and long term growth – from September 2013 provides an excellent insight. The process still has a number of years to run. Meanwhile, pegging the RMB to the US$ has made China uncompetitive in certain export markets. Other countries have filled the void, Mexico, for example, now appears to have a competitive advantage in terms of labour costs whilst transportation costs are definitely in its favour when meeting demand for goods from the US. This April 2013 article from the Financial Times – Mexican labour: cheaper than China elaborates:-

Mexico_vs_China_-_wages_Merrill_Lynch

Source: BofA Merrill Lynch

China’s economy continues to slow, a lower RMB is not unexpected but how are the major economies faring under these conditions?

US growth and lower oil prices?

I recently wrote about the US economy – US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment? My conclusion was that US stock earnings were improving. The majority of Q2 earnings reports have been released and the improvement is broad-based. This article from Pictet – US and Europe Q2 Earnings Results: positive surprises but no game changer which was published last week, looks at both the US and Europe:-

US earnings: strong profit margins and strong financials

Almost all S&P500 (456) companies published their Q2 results. At the sales level, 46% of companies beat their estimates; meanwhile, the corresponding number was 54% at the net profit level. Companies beat their sales and net profit estimates by 1.2% and 2.2% respectively, thus demonstrating strong cost control. Financials were big contributors as sales and net profit surprises came out at +0.5% and 1.5% respectively excluding this sector. Banks (37% of financials) beat sales estimates by 9% sales surprises and 8.4% at the net profit level. This sector’s hit ratio was especially impressive with 92% of reporting companies ahead of the street estimates. Oil and gas companies, which suffered from very large downgrades in 2015, reported earnings in line with expectations. Sales of material-related sectors (basic resources, chemicals, construction materials) suffered from the decline in global commodity prices, but those companies were able to post better than expected net profits. While positive, these numbers were not sufficient to alter the general US earnings picture. Thus the 2015 expected growth remains anaemic at 1.6% for the whole S&P500 and at 9.1% excluding the oil sector.

Q2 GDP came out at 2.3% vs forecasts of 2.6%, nonetheless, this was robust enough to raise expectations of a September rate increase from the FOMC.

European growth – lower oil a benefit?

The European Q2 reporting season is still in train, however, roughly half the earnings reports have now been published; here’s Pictet’s commentary:-

European earnings: positive surprises, strong banks but no substantial currency impact

A little more than half of Stoxx Europe 600 constituents published their numbers. Sales and net earnings surprises came out at 4% and 4.3% respectively. Excluding financials, the beat was less impressive with 0.8% at the sales level and 2.7% at the net income level. Banks had a strong quarter on the back of a rebound in loan volumes and improvements in some peripheral economies. This sector’s published sales and net income were thus 33% and 11% higher respectively than estimates. One of the key questions going into the earnings season was whether the very weak euro would boost European earnings. Unfortunately, this element failed to impact Q2 earning in a meaningful way. Investors counting on the weaker currency to boost European companies’ profit margins were clearly disappointed as this process remains very gradual. Thus, European corporates’ profit margins remain well below their US counterparts (11% versus 15%).

The weakness of the oil price doesn’t appear to have had a significant impact on European growth. This video from Bruegel – The impact of the oil price on the EU economy from early June, suggests that the benefit of lower energy prices may still feed through to the wider European economy, however they conclude that the weakening of prices for industrial materials supports the view that the driver of lower oil prices is a weakening in the global economy rather than the result of a positive supply shock. The views expressed by Lutz Kilian, Professor of Economics at the University of Michigan, are particularly worth considering – he sees the oil price decline as being a marginal benefit to the global economy at best.

When attempting to gain a sense of how economic conditions are changing, I find it useful to visit a country or region. The UK appears to be in reasonably rude health by this measure, however, mainland Europe has been buffeted by another Greek crisis during the last few months, so my visit to Spain, this summer, provided a useful opportunity for observation. The country seems more prosperous than last year – albeit I visited a different province – despite the lingering problems of excess debt and the overhang of housing stock. The informal economy, always more flexible than its regulated relation, seems to be thriving, but most of the seasonal workers are non-Spanish – mainly of North African descent. This suggests that the economic adjustment process has not yet run its course – unemployment benefits are still sufficiently generous to make menial work unattractive, whilst unemployment remains stubbornly high:-

spain-unemployment- youth unemployment rate

Source: Trading Economics

Euro area youth unemployment remains stubbornly high at 22% – down from 24% in 2013 but well above the average for the period prior to the 2008 financial crisis (15%).

If structural reforms are working, Greece should be leading the adjustment process. Wages should be falling and, as the country regains competitiveness, and employment opportunities should rise:-

greece-german unemployment-rate

Source: Trading Economics

The chart above shows Greek vs German unemployment since the introduction of the Euro in 1999. Germany always had structurally lower unemployment and a much smaller “black economy”. During the early part of the 2000’s it suffered from a lack of competitiveness whilst other Eurozone countries benefitted from the introduction of the Euro. Between 2003 and 2005 Germany introduced the Hartz labour reforms. Whilst average earnings in Germany remained stagnant its economic competitiveness dramatically improved.

During the same period Greek wages increased substantially, the Greek government issued a vast swathe of debt and unemployment fell marginally – until the 2008 crisis. Since 2013 the adjustment process has begun to reduce unemployment, yet, with youth unemployment (see chart below) still above 50% and migrants arriving by the thousands, this summer, it appears as though the economic adjustment process has barely begun:-

greece-german youth-unemployment-rate

Source: Trading Economics

Japan – has Abenomics failed?

Japanese Q2 GDP was -1.6% y/y, Q1 was revised to an annualised +4.5% from 3.9% – itself a revision from 2.4%, so there may be room for some improvement in subsequent revisions. The weakness was blamed on lower exports to the US and China – despite policies designed to depreciate the JYP – and a weather related lack of domestic demand. The IMF – Conference Call from 23rd July urged greater efforts to stimulate growth by means of “third arrow” structural reform:-

In terms of the outlook for growth, we project growth at 0.8 percent in 2015 and 1.2 percent in 2016, and potential growth over the medium term under current policies we estimate to be about 0.6 percent. Although this near-term growth forecast looks modest, we would like to emphasize that it is above potential and, therefore, we think that the output gap will be closing by early 2017.

Still, we need to emphasize that the risks are on the downside, including from external developments, weaker growth in the United States and China, and global financial turbulence that could lead to safe haven appreciation of the yen, which would take the wind out of the recovery to some degree.

The key domestic risks include weaker than expected real wage growth in the short term and weak domestic demand and incomplete fiscal and structural reforms over the medium term. These scenarios could result in stagnation or stagflation and trigger a jump in JGB yields.

 

Conclusions and investment opportunities

I want to start by reviewing the markets; here are three charts comparing equities vs 10yr government bonds – for the Eurozone I’ve used German Bunds as a surrogate:-

Dow - T-Bond 2008-2015

Source: Trading Economics

Eurostoxx - Bunds - 2008-2015

Source: Trading Economics

Nikkei - JGB 2008-2015

Source: Trading Economics

With the exception of the Dow – and its pattern is similar on the S&P500 – the uptrend in stocks hasn’t been broken, nonetheless, a significant stock market correction is overdue. Below is a 10 year monthly chart for the S&P500:-

S&P500 10yr

Source: Barchart.com

US Stocks

Looking at the chart above, a retest of the November 2007 highs (1545) would not be unreasonable – I would certainly view this as a buying opportunity from a shorter term trading perspective. A break of the October 2014 low (1821) may presage a move towards this level, but for the moment I remain neutral. This is a change to my position earlier this year, when I had become more positive on the prospects for US stocks – earnings may have improved, but the recent price action suggests doubts are growing about the ability of US corporates to deliver sufficient multi-year growth to justify the current price-multiples in the face of potential central bank rate increases.

US Bonds

T-Bonds have been a short term beneficiary of “flight to quality” flows. A more gradual move lower in stocks will favour Treasuries but FOMC rate increases will lead to curve-flattening and may completely counter this effect. Should the FOMC relent – and the markets may well test their mettle – it will be a reactive, rather than a proactive move. The market will perceive the rate increases as merely postponed. Longer duration bonds will be less susceptible to the vagaries of the stock market and will offer a more attractive yield by way of recompense when a new tightening cycle begin in earnest.

Europe and Japan – stocks and bonds

Since the recent stock market decline and bond market rally are a reaction to the exogenous impact of China’s economic fortunes, I expect correlation between the major markets to increase – whither the US so goes the world.

The US$ – conundrum

Finally, I feel compelled to mention the recent price action of the US$ Index:-

US Dollar Index

Source: Barchart.com

Having been the beneficiary of significant inflows over the past two years, the US$ has weakened versus its main trading partners since the beginning of 2015, however, the value of the US$ has been artificially reduced over multiple years by the pegging of emerging market currencies to the world’s reserve currency – especially the Chinese RMB. The initial reaction to the RMB devaluation on 12th August was a weakening of the US$ as “risk” trades were unwound. The market correction this week has seen a continuation of this process. Once the deleveraging and risk-off phase has run its course – which may take some weeks – fundamental factors should favour the US$. The FOMC is still more likely to raise rates before other major central banks, whilst concern about the relative fragility of the economies of emerging markets, Japan and Europe all favour a renewed strengthening of the US$.