The wise ole bond market is supposed to be the great sage of pending recessions. A flat yield curve? Ut-oh, the economy is faltering. An inverted yield curve? Wall Street is convinced economic contraction is merely a quarter or two away.
In a world where stocks are bonds (thanks to dividend yield) and bonds are stocks (thanks to principal gains), the bond market may be totally wrong about a recession next year. Even the year after.
For some wise guys, the economy is so fundamentally sound that banks and lenders are willing to give borrowers a haircut on what is owed to them just so they can lend money.
“I don’t believe there is a recession coming,” says Alex Ely, chief investment officer for U.S. small to mid-cap growth equity at Macquarie Investment Management. “Consumers are not extended. Unemployment levels are low and wage growth is high so we are optimistic,” he says, adding that 2020 looks fine.
The only people talking about a recession are bond managers, and maybe a few political pundits hoping a contracting economy and falling stock market means President Trump loses his re-election bid.
Macquarie is forecasting 1.3% yield on the 10-year Treasury bond at some point next year. The 10-year yield is 1.81% as of Monday’s close.
Despite that low yield, the vast majority of investments in investment grade debt is in U.S. Treasuries, keeping the dollar strong.
That trend could easily continue next year, a headwind for emerging markets in particular which benefit more from a weaker dollar.
The Federal Open Market Committee cut the fed funds rate by 25 basis points in late October with another one expected soon. Despite low inflation, a strong job market and decent wage growth, Fed chairman Jerome Powell hinted that there were headwinds from the trade war that caused them to reduce the cost of capital. Everyone called it an “insurance” rate cut.
President Trump took to Twitter again on Monday to roast the Fed on being too…hawkish. He wants … [+] more rate cuts to better compete with Europe, and in hopes they will sour demand for the strong dollar. Photographer: Sarah Silbiger/Bloomberg
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“Two things stood out to me with their last decision. First, rather than stressing the downside risks to growth and inflation, their outlook is more balanced — so they’ve cut this time with a view of remaining on hold for the foreseeable future. And second, there’s a view that rates are now appropriately accommodative, which means they think they’ve bought enough insurance going to stay on hold into 2020,” says Edward Al-Hussainy, senior interest rate and currency analyst for Columbia Threadneedle.
Going into 2020, Powell seems to be placing an emphasis on cyclical factors, which could potentially be solved with short precautionary rate cuts, versus structural factors, which would require more easing.
Over the next six to 12 months, the market is pricing in just a 10% chance of one more cut.
“I think, at best, that things in the U.S. economy are deteriorating at a slower pace,” says Al-Hussainy. Outside of the U.S., in places like Europe and Japan, economic data is lackluster. Moreover, there’s no certainty of the phase 1 China-U.S. mini-deal getting approved. “I’m fairly comfortable saying that additional cuts may be possible,” he says.
A slowing economy doesn’t mean a recession is right around the corner.
If the bond market is wrong, and the flattening yield curve is not an indicator of difficulties ahead, then global investors really need to pay careful attention to the credit market as the alternative indicator.
“Credit is definitely flowing into the economy,” says Brett Lewthwaite, chief investment officer for Macquarie fixed income. “The bond market rarely gets recessions wrong, but the chase for yield may be keeping the credit markets going.”
That chase for yield may also be driving demand for anything with a pulse.
Higher yielding emerging market debt, when new issues are brought to market, are always over subscribed.
In the developed world, investors will only get paid over 2% annually if they buy bonds with a minimum maturity of 20 years. Germany’s 10 year takes your money and keeps taking it, with negative 0.35% yield.
Frankfurt, Germany on Monday, Dec. 2, 2019. The only way investors are making money on German … [+] government bonds is if yields go even more negative and they can realize capital gains on the bond price. (AP Photo/Michael Probst)
Switzerland takes the cake. Investors with a 50 year hold on government bonds better hope for yields to go even lower if they want to realize any gains at all because yields are currently -0.09%.
There is an estimated $11.8 trillion of negative sovereign debt in the market, with a little over a trillion dollars worth of negative corporate bonds, all of it in Europe. That’s been the case for over a year now.
German bond markets may have been onto something, however. Second quarter GDP contracted by 0.1%. Then again, the third quarter reversed that loss, with Germany quarterly GDP up 0.1%, meaning German GDP hasn’t grown on a quarterly basis since June.