Called Into Question

A key market gauge of recession,
The yield curve, has called into question
Growth’s pace up ahead
And whether the Fed
Will restart financial repression

While markets this morning have stopped falling, there is no question that investors are on heightened alert. Yesterday saw further declines in the major stock indices and a continuation of the dollar’s rally alongside demand for Treasuries and Bunds. Today’s pause is hardly enough to change the predominant current view which can best be summed up as, AAAAGGGHHHH!

In the Treasury market, 10-year yields reached their steepest inversion vs. 3-month yields, 14bps, since 2007. While many pundits and analysts focus on the 2-year vs. 10-year spread, which remains slightly positive, the Fed itself has published research showing the 3-month vs. 10-year spread is a better indicator of future recessions. So the combination of fears over a drawn out trade war between the US and China and ongoing uncertainty in Europe given the Brexit drama and the uptick in tensions between Italy and the European Commission regarding Italy’s mooted budget, have been enough to send many investors hunting for the safest assets they can find. In this classic risk-off scenario, the fact that the dollar and the yen remain the currencies of choice is no surprise.

But let’s unpack the stories to see if the fear is warranted. On the trade front, every indication of late is that both sides are preparing for a much longer conflict. Just this morning China halted all imports of US soybeans. The other chatter of note is the idea that the Chinese may soon halt shipments of rare-earth metals to US industry, an act that would have significant negative consequences for the US manufacturing capability in the technology and aerospace industries. Of course, the US ban on Huawei and its increased pressure to prevent any allies from buying their equipment strikes at the heart of China’s attempts to move up the value chain in manufacturing. All told, until the G20 meeting in about a month’s time, I cannot foresee any thaw in this battle, and so expect continued negative consequences for the market.

As to Brexit, given the timing is that there won’t be a new Prime Minister until September, it seems that very little will happen in this arena. After all, Boris Johnson is already the favorite and is on record as saying a hard Brexit suits him just fine. While my personal view is that the probability of that outcome is more than 30%, I am in the minority. In fact, I would argue the analyst community, although not yet the market, is coalescing around the idea that no Brexit at all has become the most likely outcome. We have heard more and more MP’s talk about a willingness to hold a second referendum and current polls show Remain well ahead in that event. Of course, the FX market has not embraced that view as evidenced by the fact the pound remains within spitting distance of its lowest levels in more than two years.

Finally, the resurrection of the Italy story is the newest addition to the market’s menu of pain, and this one seems like it has more legs. Remarkably, the European Commission, headed by Jean-Claude Juncker, is demanding that Italy reduce its fiscal spending by 1.5% of GDP despite the fact that it is just emerging from a recession and growth this year is forecast to be only 0.3%. This is remarkable given the Keynesian bent of almost all global policymakers. Meanwhile, Matteo Salvini, the leader of the League whose power is growing after his party had a very strong showing in last week’s EU elections, has categorically rejected that policy prescription.

But of more interest is the fact that the Italian Treasury is back to discussing the issuance of ‘minibots’ which are essentially short-term Italian notes used by the government to pay contractors, and which will be able to trade in the market as a parallel currency to the euro. While they will be completely domestic, they represent a grave threat to the sanctity of the single currency and will not be lightly tolerated by the ECB or any other Eurozone government. And yet, it is not clear what the rest of Europe can do to stop things. The threat of a fine is ludicrous, especially given that Italy’s budget deficit is forecast to be smaller than France’s, where no threats have been made. The thing is, introduction of a parallel currency is a step into the unknown, and one that, in the short-term, is likely to weigh on the euro significantly. However, longer term, if Italy, which is generally perceived as one of the weaker links in the Eurozone, were to leave, perhaps that would strengthen the remaining bloc on a macroeconomic basis and the euro with it.

With that as background, it is no surprise that investors have been shunning risk. While this morning markets are rebounding slightly, with equity indices higher by a few tenths of a percent and Treasury yields higher by 3bps, the trend remains firmly in the direction of less risk not more.

The final question to be asked is, how will the Fed respond to this widening array of economic issues? Arguably, they will continue to focus on the US story, which while slowing, remains the least problematic of the major economies. At least that has been the case thus far. But today we have the opportunity to change things. Data this morning includes the first revision of Q1 GDP (exp 3.1%) as well as Initial Claims (215K) and the Goods Trade Balance (-$72.0B) at 8:30. There are concerns that the Q1 data falls below 3.0% which would not only be politically inconvenient, but perhaps a harbinger of a faster slowdown in Q2. Then, throughout the next week we get a significant run of data culminating in the payroll report next Friday. So, for now, the Fed is going to be watching closely, as will all market participants.

The predominant view remains that growth around the world is slowing and that the next easing cycle is imminent (fed funds futures are pricing in 3 rate cuts by the end of 2020!) However, Fed commentary has not backed up that view as yet. We will need to see the data to have a better idea, but for now, with risk still being shunned, the dollar should remain bid overall.

Good luck