September 2, 2019 Satyendra Nayak - Consultant-Spectrafin, Author, Speaker
US stock market crash by 3% with Dow plunging down by 800 points is one of the worst falls in recent years. News of economy’s growth momentum, Fed moves, market perception and reaction, and tussle on trade tariffs have all gone to cloud the US economic environment and sentiment with a considerable degree of uncertainty and suspense.
Let us take each of these factors one by one. US economy has been on a growth cycle since 2016. The real GDP growth of 1.6% in 2016 rose to 2.4% in 2017 and 2.9% in 2018. During 2018 the Fed raised Fed funds rate four times from 1.5% to 2.5%. Slowdown in growth was visible in Q4 in 2018 when it declined to 1.1%. Yet the growth rate recovered in Q1 2019 to 3.1% and recorded 2.1% in Q2.
Decline in Q4’18 was primarily caused by decline in the private investment growth to 3% from very high rate of 13.7% in Q3’18. In Q2’19 private investment fell by 5.5%, exports declined by 5.2%, and growth rate declined to 2.1%.
While unemployment is at the record low of 3.7% in last 50 years, inflation rate for urban consumers for all items in July 2.2% and 1.8% excluding food and energy items.
The economy is not yet in recession, but there are signs of slowdown from domestic environment as well as global trends. Europe and Japan are still to recover and gain growth momentum. Both are in negative interest rate zone. China is also slowing down and the US trade battle with China, Europe, Canada, Mexico and other nations may slow down US exports growth.
Fed’s rate cut of 0.25%in July did not go well with the markets which desired 0.5% rate cut. The market claim for rate curt was not only based on the declining consumer confidence and investment sentiments, but also the negative interest rates on the other side of developed world. 1.75 to 2% interest rate differential between Germany-Japan and US is large to invite capital inflow into the US. palatable. It is also driving dollar stronger adversely affecting exports.
Full Yield Curve Saucer Shaped, not Inverted
Although the yield curve of between the 1 month and 10 year Treasury is inverted, it is only a third of the full yield curve. On August 14, 2019 yield on Treasury shows a decline from 1.98% to 1.46%. But it moves up to 1.84% for 20 years Treasury and to 2% for 30 years. Hence, we have Saucer shaped yield curve, with the yield declining until 10 years, but rising back to higher level for 30 year Treasury.
Of late the phenomenon of half way inverted curve has stirred up a speculation that it is a sign of imminent recession. If you ignore the yield slide from 1 year to 10 years Treasury, the yield curve for Treasuries is actually flat at 2% from 1 month to 30 years. Is the Inverted(Saucer)-Flat yield curve sign of recession?
Negative Yield Bond Market
Since 2014 when sovereign debt started yielding negative returns the size of investment grade corporate and sovereign bonds from Europe and Japan has risen manifolds to $ 14 trillion accounting for 24% of global investment grade debt. European government bonds with negative yields has reached a figure of $5 trillion. 88% of German government bonds, 74% of Japanese bonds and 76% of French bonds are yielding negative yield.
In this scenario US T bills and bond market stands out very positively. US Treasury and Bonds of $16 trillion forms 70% of global sovereign bonds market. It is a formidable size and strength in the global financial markets. Foreign Government holdings of US T bills and bonds amounts to $6 trillion. Looking to the size of the negative yielding market of $16 trillion and the positive interest differential of 1.75% to 2% between the German and Japanese government bond, the foreign investment in US bonds is increasing. Downward pressure on the yields on US bonds is exerted by foreign capital inflows into US bonds. Recently former Fed Chair Janet Yellen expressed this view. The inverted yield curve is a reflection of this interest rate differential and also the market view that in the medium term the interest rates will remain low due lower global growth forecast.
Slow Down, Recession or Financial Turmoil
Whether it is inverted or saucer or flat yield curve, it reflects the market view of not giving premium for holding long dated Treasuries over 1 year. Market is always forward looking. Sometimes more speculative or irrational, but always looks at the Risk-Reward matrix. It wants to shun risks and grab rewards in its perception of future.
What is message from the market from the unusual and abnormal Treasury yield curve? The yield curve reflects both the US economic and monetary situation as well as international perception of the global and US economy. Slower growth in Europe, Japan, China and possibly US are a concern. The negative sentiment is further compounded by the tariff struggle affecting trade and investment. If lower growth becomes a reality in 2020, the interest rates in the US will have come down from the current level. This growth perspective is influencing interest rate expectations that is actually bringing downward pressure on US Treasury yields. The negative interest rate scenario is compounding this effect by increasing the demand for US Treasuries, regarded as the financial safe haven in current uncertain times.
Yet another factor impinging on the yield curve is the growing risks in the debt or financial markets that may cause a financial turmoil. Will the Black Swan of 2008 glide again? Argentinian debt crisis is on the horizon. Debt levels globally in household, corporate and government accounts are continuing to rise without any respite. Will the US be forced to go to near zero interest rate to salvage the financial markets and economy? These are the concerns which are manifest in the US Treasury yield curve.