US yield curve re­flects fun­da­men­tal in­vestor mind­set shift

Gulf Times Business - - BUSINESS - By Jamie McGeever

The re­ces­sion warn­ing sent out by a rapidly flat­ten­ing US Trea­sury yield curve is loud and clear, but the move since the week­end ‘trade truce’ also re­veals a sig­nif­i­cant turn in in­vestor sen­ti­ment over the past cou­ple of months.

De­spite a re­lieved surge in world stock mar­kets on Mon­day af­ter Wash­ing­ton and Beijing called a 90-day halt on new tar­iffs, the gap be­tween two- and 10-year Trea­sury yields has shrunk to its nar­row­est since 2007 to only 13 ba­sis points from an in­ver­sion that many say her­alds the on­set of re­ces­sion.

The move stopped the eq­uity mar­ket in its tracks as in­vestors quickly re­fo­cused on the risk that the age­ing eco­nomic cy­cle rolls over, rather than a tac­ti­cal shift in the trade war. The speed with which the eu­pho­ria faded was one of the clear­est signs yet of a fun­da­men­tal shift in in­vestor be­hav­iour from years of “buy the dip” to “sell the rally”. Day-to-day de­vel­op­ments are now tak­ing a back seat to the big­ger pic­ture.

For most of 2018, cer­tainly from Fe­bru­ary on­wards, in­vestors’ risk ap­petite was undi­min­ished, even against a back­drop of ris­ing US in­ter­est rates, strength­en­ing dol­lar and brew­ing trade war. At least as far as Wall Street was con­cerned.

The yield curve flat­tened through all that, yet US as­set prices rose.

The nar­ra­tive went largely like this: the econ­omy was strong enough to war­rant higher rates, while the flat­ten­ing curve and loom­ing in­ver­sion no longer had the same pre­dic­tive powers of the past. This time it was dif­fer­ent, so Wall Street con­tin­ued to per­form very well.

But that nar­ra­tive is fad­ing. Now, there’s an un­mis­tak­able feel­ing that time is be­ing called on one of long­est US eco­nomic ex­pan­sions and bull mar­kets in his­tory, the Fed is too ag­gres­sive on mon­e­tary tight­en­ing, and the out­look for re­turns next year is dark­en­ing.

In­vestors are be­hav­ing ac­cord­ingly. Ad­justed for volatil­ity, cash now of­fers bet­ter re­turns than US eq­ui­ties for the first time in a decade, ac­cord­ing to JP Mor­gan As­set Man­age­ment, who are now an­tic­i­pat­ing “an en­vi­ron­ment of slow­ing earn­ings growth and ris­ing macroe­co­nomic risks”. Re­cent eq­uity mar­ket bounces on the back of sur­pris­ingly strong eco­nomic data or good news head­lines on global trade, for ex­am­ple, are in­creas­ingly short­lived.

Ac­cord­ing to Mor­gan Stan­ley, 2018 is the first year since the early 2000s where “buy the dip” trad­ing strate­gies have failed. Just as po­ten­tially neg­a­tive data and news didn’t re­ally mat­ter ear­lier this year when mar­kets were on the up, so it ap­pears now that any “good” news flow is strug­gling to hold back the grow­ing tide of sell­ers.

The S&P 500 lost 7% in Oc­to­ber, its worst month in seven years; the mar­ket cap of the five ‘FAANGs’ fell as much as $1tn, push­ing the Nas­daq down as much as 16%; and the yield curve re­sumed its flat­ten­ing trend at an eye­catch­ing pace, to 13 bps from 37 bps only two months ago.

Wall Street and the MSCI world in­dex have halved these losses, but the up­ward mo­men­tum is fad­ing.

The trade war “truce” be­tween the United States and China struck at the G20 sum­mit in Ar­gentina over the week­end was worth a re­lief rally on global stock mar­kets that barely lasted 24 hours.

Mean­while, oil prices plunged more than 30% since early Oc­to­ber, se­nior Fed of­fi­cials have started to in­di­cate rates may not have much more to go on the up­side, and money mar­kets have moved to price in only one full quar­ter­point hike next year.

The con­sen­sus among mar­ket strate­gists is for US eq­uity re­turns in the high sin­gle dig­its.

That’s well down from around 25-30% this year but still bet­ter than Europe. Next year is likely to be char­ac­terised by “dis­ap­point­ing growth and a much nar­rower range of val­u­a­tion” against a sharp de­cel­er­a­tion in eco­nomic growth, Mor­gan Stan­ley’s US eq­uity strat­egy team wrote in their 2019 out­look yes­ter­day.

“There is a greater than 50% chance we ex­pe­ri­ence a mod­est earn­ings re­ces­sion in 2019.

This is likely to be off­set some­what by a Fed that pauses its rate hike cam­paign by June,” they wrote. Econ­o­mists at Gold­man Sachs and JP Mor­gan re­tain their call for four Fed rate hikes next year. That’s look­ing like a very bold call in­deed.

Hardly any­one ex­pects a US re­ces­sion next year, although the chances of that hap­pen­ing in 2020 are any­where be­tween 20% and 35%.

An in­ver­sion of the 2s/10s US yield curve has pre­ceded ev­ery re­ces­sion over the last 50 years.

It re­mains to be seen if the curve in­verts and if re­ces­sion fol­lows.

The for­mer looks likely, and parts of the curve at the short end, like the dif­fer­ence be­tween three- and five-year yields, have al­ready in­verted.

The warn­ing signs are there, and in­vestors are sit­ting up and tak­ing no­tice.

Jamie McGeever is a colum­nist for Reuters. The views ex­pressed are those of the au­thor.

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