Well, that didn’t last long. What we speak of is the all-too brief risk-on rally that followed the higher-than-expected July CPI and the tariff delay on some consumer goods. It lasted less than 24 hours. The 30-year bond has dipped to a new record low yield of 2.01% overnight while the 2yr-10yr spread briefly went inverted by 2bps as well. The impetus for the move was a combination of the weakest Chinese industrial production in 17 years and a negative second quarter GDP in Germany. The UK 2yr-10yr curve has inverted for the first time since 2008 and the German 10yr bund hit a new low yield of –0.64%. It seems the fear of global slowing and recession is back in full force, and with the higher inflation readings, and some backpedaling on the China trade front, the question is whether the Fed will be timid in continuing with their “mid-cycle adjustments.” While the hotter-than-expected inflation news doesn’t prevent a rate cut in September, the market is wondering if it limits the cut to 25bps instead of 50bps that was speculated in some quarters. Some of the rally in the longer end of the Treasury curve stems from the thought that the Fed may act too cautiously in the months ahead and allow the global slowdown to wash more broadly across our shores. For it’s part, the market still sees a total of 75bps in rate cuts in 2019. The question starting to be asked is, “will those cuts be enough to prevent a slowdown/recession domestically?” We take a look at that question in more detail below.
Let’s take a look at both news items from yesterday and the long-run Fed implications. First, July CPI beat expectations gaining 0.3% for the month both in the overall series and core (ex-food and energy). Expectations had the overall gaining 0.3% but the core falling back to 0.2% after a 0.3% surprise in June. The back-to-back 0.3% gain in core is the first time that has happened since 2006. The monthly gains fed increases in the year-over-year rate to 1.7% from 1.6% overall and 2.2% from 2.1% core, the highest since January. In addition, the core rate was not driven higher by owners equivalent rent which gained 0.2% versus the 0.3% rate it had been running for the last several months. Instead, the core rate ran above expectations because transportation increased 0.8%, used cars and trucks gained 0.9%, medical care gained 0.5% and apparel rose 0.4%.
The upside surprise and the broad-based nature of the gain probably forces the Fed to have second thoughts of cutting rates 50bps at the September meeting. And in thinking ahead, it may temper the Fed’s rate-cutting ambitions given the Phillips curve bent that many of the senior Fed members harbor. In that regard, part of the rally we’re seeing in the long end today is due to the thought the Fed may go timid on rate cuts and fail to provide adequate monetary stimulus allowing the global slowdown to reach our shores sooner.
As for the delay in tariffs that were set to go in effect on September, a couple things come to mind. First, the delay is on consumer products: cellphones, laptops, video games and other toys which is tacit acknowledgement that consumers were about to bear the brunt of this round of tariffs, despite what Navarro and others asserted was a bill the Chinese were paying. Second, while a knee-jerk risk-on reaction was understandable it doesn’t necessarily indicate an opening to a broader trade agreement. If anything it looks like a unilateral relent without the Chinese offering any type of quid pro-quo. Thus, China could very well continue to stall negotiations knowing that the tariffs already in place are exacting some measure of pain, and if that pain also results in stock selling well then it seems we’ve hit on the president’s reaction function in regards to trade negotiations.
It’s also should be noted that even before the overnight news on China industrial production and German GDP, the two events: CPI and delayed tariffs resulted in only a modest pullback on Treasuries. The 10-year note price dropped 12/32nds while the 30-year fell 14/32nds. The 2yr-10yr yield spread dropped to 2.5bps, the narrowest in more than twelve years. With the yield back-up on the short-end thanks to the CPI read, the inevitability of an inverted 2yr/10yr curve seemed apparent and the overnight news was indeed enough to push us there. And let’s not forget the flight-to-safety potential in the ongoing Hong Kong crisis. The longer it continues China’s patience will be tested to the point a Tiananmen Square moment may yet be in the offing.
Combining a 2yr-10yr inversion to the nearly month-long inversion of the 3mo-10yr curve will certainly get the Fed’s attention. While we don’t necessarily subscribe to the “inversion means imminent recession”, it does certainly bring concern that the market is losing confidence that the Fed, and other central banks, can stem a global slowdown with just rate cuts.
With $16 trillion now in negative yielding global debt,. high yields are not the cause of the slowdown. It’s just that when the only tool you have is a hammer (rate policy) everything looks like a nail. Meanwhile, fiscal policy solutions to the global crisis remain absent. In concluding today’s gloomy note, it should be noted that with past inversions the time to recession has averaged about 15 months. So even with an inversion today it signals a possible recession sometime in late 2020. Can the Fed forestall that and navigate a soft landing with rate cuts? It remains to be seen, of course, but the market right now is betting that it won’t.
2yr-10yr Treasury Spread Nears Inversion
With the 2yr-10yr Treasury spread dipping into inverted territory overnight for the first time in twelve years it begs the question does it really matter? The graph shows the 2yr-10yr spread going back through the last five recessions (red-shaded areas). As can be seen, and particularly in the last three recessions, an inversion clearly preceded the recession and it didn’t take much of an inversion. Clearly then a 2yr-10yr inversion has strong signaling for a coming recession and that alone could be enough to keep the Fed in rate-cutting mode as they cut front–end yields to try and forestall the inversion. The rally on the long-end, however, is partly rooted in the belief that the Fed’s rate-cutting won’t be sufficient to rekindle stronger growth.
Agency Indications — FNMA / FHLMC Callable Rates
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