As 2014 draws to a close, the financial landscape is definitely a tale of two disparate economies as the U.S. reports 5 percent GDP while Europe struggles to maintain zero growth and avoid “recession.” (I despise the official definition of a recession being two consecutive quarters of negative growth.) In Spain, Italy, Greece Portugal, France and other countries, double-digit unemployment defines a recession and the potential it brings for political turmoil.
The proof lies in the movement of yield curves. The U.S. 2/10 curve is flattening but it is a bearish flattener as the short end is climbing in yield while the long end remains bid. U.S. 10-year notes and 30-year bonds have been in demand as the European recession has sent global investors searching for premium investments with a higher yield than in the European sovereign debt market. German bunds are yielding 170 basis points less than the comparable U.S. 10-year note. If you are a European investor you get the added gain of an appreciating dollar (the classic carry trade).
The Italian and Spanish 10-year notes are also yielding 40 basis points more than the U.S., which lends further support to American sovereign debt and providing the support to the long-end of the yield curve. The European curves are flattening as bond yields tumble in investors’ anticipation of a QE program and/or a continued deepening of the recession and possible deflation. In a severe deflationary spiral the fall in prices creates a rise in real yields. (If inflation becomes negative by one percent a nominal interest rate of 1.5 percent becomes a real yield of 2.5 percent.)
The rise in real yields was what kept Japanese long bonds a desirable investment of domestic Japanese investors for the past two decades. The current flattening in the European yield curves is the exact opposite of the flattening that prompted Mario Draghi to make his famous, “NO TABOOS AND WHATEVER IT TAKES” pledge to European and international investors. In July 2012,the European curves were BEAR FLATTENERS as the world was concerned about the entire EU project and were selling two-year notes in fear of several of the PIIGS leaving the EURO. The curve FLATTENED for fear of a funding crisis for several of the European peripheral states.
The recent action in the European curve is not a sovereign debt crisis but a fear of deflation and it is this fear that is keeping Draghi searching for an accord with the Bundesbank leaders to secure an agreement on a genuine QE program. Investors and domestic European banks are aggressively purchasing the long-end of the curve driving down long yields. The German, French, Belgium, Netherlands curves are all flatter than during the 2012 funding crisis. The Spanish and Italian 2/10 curves are still wider than the dark days of July 2012 when their 2/10s had narrowed to 75 basis points. Draghi has to be very concerned that the yield curve complex with no QE in place is signaling a renewed slowdown with deflation a real possibility. In a European economic system saddled with large amounts of debt a deflation scenario good have severe political ramifications. This is the landscape as we enter 2015.
The U.S. situation is much different as improved economic performance has led to a decrease in unemployment and other economic barometers. As the rest of the world has struggled to increase growth the U.S. has been the recipient of investors search for higher yields and greater possible returns in equity markets. The U.S. dollar has by default become the investment choice and the stronger dollar has been able to push import prices lower causing the FED to be concerned about inflation falling to levels not commensurate with its “dual mandate.” Low inflation gives Chair Yellen a reason to keep present ZIRP in place.
The minutes from the December FOMC meeting (to be released January 7) will be an important measure of the FOMC‘s concern for the strength of the dollar and the decline in the global economic performance. If the MINUTES reflect a growing concern about Europe the two-year note yield will drop and the 2/10 U.S. curve will steepen as the front end has been pricing in a more aggressive Fed raising rates in the end of the first quarter or early second.
The FED has been nonchalant about the European situation except that Treasury Secretary Lew has warned Brussels about competitively devaluing the euro in any attempt to gain a trade advantage in violation of previous G-20 agreements. If the U.S. curve flattening is a result of fear of European economic problems the Fed cannot be treating it with benign neglect. The factors I have put forward are why the yield curves will be extraordinarily important in the coming year. What we will pay attention to is the possible trades that can arise from the TALE Of TWO YIELD CURVES.
***Friday, the precious metals had a sizable rally even as the SPOOS and other equity markets powered upward. The reason given for the rally was a report of China waiving reserve requirements for some deposits. “Commercial lenders won’t be required to set aside reserves for the savings that they hold for non-deposit-taking financial institutions ….” (Bloomberg) The proposed change is to loosen the lending guidelines and allow more liquidity into the banking system easing tightening conditions in the credit markets. The Chinese use the reserve requirement as a tool to constrict or broaden the flow of credit in the economy. The Bloomberg article reports that the change may “… add 7 trillion yuan ($1.1 trillion) of money [that] will be classified as deposits ….” (Not an inconsiderable amount.)
Following on the Friday’s announcement from the Chinese, in tomorrow’s Financial Times there is an article, “China Zombie Factories Kept Open to Give Illusion of Prosperity.” The thrust of the article is that the Chinese have industrial over capacity that is generating no profit but being propped up by state and local government. The threat of Chinese mass exports at loss generating prices will act to be a damper on global inflation. This is also acting to drive yield curves flatter. The Japanese currency devaluation is also having an impact on global prices as multinational corporations struggle to maintain market sure against foreign-based firms with a competitive advantage of a weakened currency.
In the usual scenario, flattening yield curves would be a negative on equity markets, commodity markets, and, of course, precious metals. BUT WITH THE WORLD’S CENTRAL BANKS AT ZERO INTEREST RATES IT IS TIME TO THROW AWAY THE CONVENTIONAL PLAYBOOK TO DISCERN OUTCOMES. WHEN A CENTRAL BANK CANNOT CUT RATES TO STIMULATE AN ECONOMY THE UNCONVENTIONAL BECOMES THE ALTERNATIVE. IT IS THE UNCONVENTIONAL ACTED OUT IN GLOBAL CONCERT THAT SHOULD KEEP THE MARKETS VOLATILE.
It is not inflation that drives investors to seek safe havens but the uncertainty of unconventional measures based only on academic theory. It was easier to land a spacecraft on a speeding comet than to undo the years of poor economic policy. After all, economic theory is truly not rocket science not matter how sophisticated the models.
Happy New Year from Notes From Underground.