Houston, we have a problem
The bond market is often seen as the most accurate indicator of what lies ahead for an economy, or at least what investors believe lies ahead. If the current gyrations in global bond markets are anything to go by, there are some serious concerns about the economic outlook. Central banks in New Zealand and India unexpectedly delivered aggressive cuts, US 10-year bonds have fallen 50 basis points in a month, and the German yield curve is the flattest it has been since the GFC.
Bond markets are complicated beasts and it can be difficult, even for sophisticated investors, to decipher these signals. Livewire reached out to four bond investors, asking them to translate these signals into plain English and to explain what they believe the implications are for investors.
Houston, we have a problem
Charlie Jamieson, Chief Investment Officer, Jamieson Coote Bonds says that bond markets have been accurate predictors to date and says the recent moves paint a worrying picture,
“Bond markets have correctly predicted the slowdown in economies so far. They predicted these rate cuts in terms of the way they were priced heading into these events. Looking forward they are predicting a much darker path.”
- Bond markets have been good predictors so far and are predicting a ‘darker path’ forward.
- Expectations that central banks globally will continue to cut interest rates.
- Rate cuts in NZ are very significant with the governor committing to do ‘whatever it takes’ to keep the economy moving. It is significant because the NZ economy tends to lead the Australian economy by about 6 – 12 months.
- Global economic conditions are likely to see Australian interest rates head towards 0.5% by February 2020.
Is the bond market signalling recession?
The rally in 10-year bond yields over the past six months has seen the spread differential between 10-year and 3-month bond yields fall to -30 basis points. Historically, this level of inversion is a signal of recession, which only occurred in 1989, 2000 and 2007 as shown below.
Chart 1: US 3-month and 10-year curve
What this bond market signal is telling us is that the market is beginning to signal that a full-scale rate cut cycle is potentially coming from the Federal Reserve (Fed). To explain this, we can use some simple arithmetic and history.
Starting with Chart 1, we can see that the average spread between 10-year and 3-month bonds since 1985 is around +1.75%. Historically speaking, Chart 2 shows that once we reach this level of curve inversion (grey bars), the curve steepens via the 3-month rate falling drastically lower (shown as the blue line (3m) dropping away, rather than the green line (10Y) rising.
Chart 2: Bond yields and 3m/10y inversion
This poses the question of how far would cash rates need to fall to normalise the 3m/10Yr curve to the average level identified above? Since 10-year bonds are currently trading at around 1.70%, this implies that the 3-month rate needs to fall to 0% to give an historically average level curve. In other words, the bond market is telling us that it’s not out of the question to expect the cash rate to fall back to zero from here.
And this leaves us with the next question: What would cause the Fed to cut 200 points?
A recession certainly jumps to mind, meaning bond yields are telling us that recession probabilities are likely higher than the market currently perceives.
The key chart to keep your eye on
One of the most important charts that we are watching now is the consistent slow-down occurring across Global Manufacturing PMI’s. We take the average PMI level of the world’s five largest exporters — US, China, Germany, South Korea and Japan — and see that the average PMI level of the world’s largest exports is now contractionary.
When we combine the slowdown of this indicator (late 2018) with the timing of the curve inversion, we arrive at the conclusion that the slow-down in global trade is having a larger effect on economic growth than previously expected. Hence investors should be watching PMI figures for either improvement or deterioration, as it will give a timely signal of how global trade is fairing.
Current signals are cause for reflection
Our current outlook is the most variable that we have seen in several years as two potentially polarised ranges are appearing. Given the US yield curve is so inverted there is a relatively high risk of recession over the next twelve months, which means we can group our expected outcomes into two buckets:
1. A recession occurs – Rates rally as the Reserve Bank of Australia (RBA) continues to cut rates (or look at Quantitative Easing) and this will pull bond yields lower.
2. Growth is fine – Interest rates stall or sell off as the RBA is able to take a break, similar to what occurred in 2013 or 2016.
Hence we need to understand where the recession probability truly sits before we are able to make a large interest rate call. If recession odds are 50-50, then the view can be thought of only as uncertain going forward. The optimist will want to state that everything will be fine and bond yields should sell off, but the signal coming from the interest rate curve should cause some reflection.
Central banks to the rescue
The conventional explanation for recent moves in the bond markets is that global bond yields are collapsing because investors fear a global recession, triggered by the US-China trade war, slowing economic momentum in Europe etc.
Our take is more nuanced. Global bond yields are collapsing in anticipation of aggressive central bank action to save economic growth from these risks. That is why we’ve only seen a small wobble so far in risky assets (i.e. equities, credit, EM), rather than a material correction.
If economic growth really was to slow to levels that are consistent with the current levels of global bond yields, risky assets would have to fall a lot further. Instead, they are still holding up relatively well on the assumption that aggressive and pre-emptive central bank rate cuts will prevent the economic downside scenario from materialising.
Looking at past 12 month returns, it’s very unusual to see such a strong rally in conventional safe havens like government bonds, while risky assets also performed very well.
This apparent inconsistency between bonds rallying fiercely, while risky assets remain near the highs, can be explained by one thing … the assumption that central banks will save the day.
The most crowded trade in global markets
We have seen record inflows to bonds, at a time when yields are already at record low levels and a record 24% of global bonds have a negative yield.
Everyone’s chasing bonds on the expectation that yields will keep falling and therefore the interest rate duration exposure inherent in those bonds will provide capital gains (lower bond yields = higher bond prices) to protect their portfolios if equities fall.
This has now become the most crowded trade across global financial markets.
While it has worked so far, how well can it keep working going forward given that the more yields fall, the more unfavourably asymmetric the risk vs return profile of duration exposure becomes? This asymmetry is what makes chasing bonds at record low yields (i.e. record high prices) very different to chasing stocks at high valuations.
This also begs the question as to whether these record bond inflows are based on considered analysis of risk vs. return dynamics or whether they are simply anchored to past performance.
Just because a position is crowded, doesn’t mean it’s wrong. However, history tells us that when strong consensus expectations and crowded positions build up, the room for disappointment grows and a potentially violent re-pricing can follow if things don’t play out as expected.
Bonds are supposed to be the safe haven that protects portfolios when equities fall but may actually end up being the catalyst for the next equity drawdown if extreme investor expectations and positioning around the ‘lower for longer’ interest rates theme is disappointed.
On this point, the strategists from BofA Merrill Lynch produced the chart below and noted the following;
“The most important flow to know: annualized inflows to bond funds = staggering record $455bn in 2019; compares with $1.7tn inflows past 10-years; positioning danger is in bonds, not stocks or commodities” – BofA Merrill Lynch, The Flow Show, July 2019
Global bond markets in a precarious position
Looking forward to Q4 and into 2020, our outlook is for more extreme volatility.
The combination of record inflows to bonds and the one-way consensus bet that rates can only go lower, at a time when bond yields are already eye-wateringly low, leaves global bond markets in a precarious position.
Anything that causes this consensus to be questioned, for example, an unexpected uptick in inflation, could cascade into a violent bond market sell-off that then spills over into other markets.
Looking at the earlier chart, note that the previous peak in bond inflows was late 2017 / early 2018 … just before the bond market sell-off that triggered 2018’s global equity drawdown.
These are unprecedented times
Jay Sivapalan, Portfolio Manager, Janus Henderson
Having lost patience with stubbornly low inflation and aiming to extend this economic growth cycle, central banks around the globe were already preparing to provide some support. The recent trade spat between the US and China has accelerated the urgency of a globally coordinated policy response. The following are just some examples of recent language used:
US Federal Reserve: “will act as appropriate”
Bank of Japan: “will not hesitate”
European Central Bank: “determined to act”
Reserve Bank of Australia: “strongly committed to making sure we get there” (inflation)
Reserve Bank of New Zealand: “Easily within the downward errors of our forecasts ... if you’re trying to stimulate ... that means you have negative interest rates”
Global bond markets have been quick to price in these sentiments ahead of actual policy moves by central banks. Bond yields in Australia, as an example, have fallen circa 50 basis points (bps) over just the past few weeks to a new record low of 0.95% (at the time of writing) for a 10 year government bond. Whilst the direction of these moves is understandable given the expectations of central bank activity over the coming months, the implied ramifications behind these yields is a little more curious.
Cash rate expectations implied by futures markets now have the Reserve Bank of Australia (RBA) cutting rates to 0.25% almost with certainty. Breakeven inflation rates (average expected annual inflation) over the next decade in Australia are now under 1.20%. Actual rolling 10 year inflation over the past 70 years has never been below about 2%. But these are unprecedented times.
In this period of uncertainty, valuations appear to have become disconnected from a range of more benign economic outcomes and are pricing in a state where economies cannot respond to stimulus. Even under neo-Keynesian regimes where fiscal policy is more proactive, there is the risk of an inflation pulse if demand measures are successful. With term premia negative, markets are demanding no compensation for this risk.
Behind this backdrop, economic conditions, including labour markets, remain resilient with unemployment rates in almost all developed economies now lower than they were over the past year, three years and indeed materially lower than 10 years ago when we exited the Global Financial Crisis. To be sure, inflation remains largely subdued against central bank targets with the exception of stronger economies like the US.
The most important chart we are watching right now
We are following labour market developments over the period ahead to assess how much work the RBA will have to do to get the unemployment rate down to its 4.5% longer term neutral rate. We largely agree with market pricing that some further policy easing will be needed for it to achieve that goal.
Resolution unlikely to occur any time soon
Bond markets have already rallied strongly and are discounting both conventional and unconventional central bank easing. To the extent that the current round of insurance easing works, which includes steps by Chinese authorities to boost domestic demand in their own economy, there is scope for markets to wind back easing expectations.
This point is unlikely to be reached this year though, with geopolitical tensions at heightened levels and the risk of a trade war-driven slowing in global manufacturing spilling over into the services sector lifting. Furthermore, the longer it takes for fiscal policy to play a more active role in supporting demand, the more pressure there is on central banks to provide support and this dynamic will maintain downward pressure on global and domestic yields.
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