March 26, 2019

With the German 10-year bunds closing last week with a yield of negative 0.03%, talk of yield curve inversion and a global recession is rampant as some short-term interest rates in the U.S. are now drifting above the 10-year Treasury yield. Still, the classic 2-10 spread, or the difference in yield between the 2-year and the 10-year Treasury notes has not inverted yet and – until it does – the jury is still out on the possibility of the present U.S. economic expansion ending.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

The issue may very well be that international demand for Treasuries in a year of record supply is rather strong. There simply isn’t any significantly positive yield in any key global government bond market, so bond buyers end up piling into the U.S. Treasury market. German 2-year federal notes, which go by the tongue-twisting name bundesschatzanweisungen, have been in negative territory for five years and closed last week at -0.55%. That means that the German 2-10 spread is a positive 52 basis points as subtracting one negative number from another results in a positive interest rate differential. Japan faces a similar situation, where the 10-year JGBs closed the week at -0.07% while the 2-year notes closed at -0.17%.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Negative yielding 10-year government bonds in major world economies are a clear sign of global deflation where overly-indebted developed economies are struggling to grow, while the overly-indebted Chinese economy has trouble picking up the slack. The headline inflation rate in both the U.S. and Germany is 1.5%, while the German economic data, such as industrial production, is noticeably weaker.

It is no wonder that the Fed has removed itself from the picture by clearly saying that they will be on the sidelines for a while when it comes to the fed funds rate. When it comes to the ongoing quantitative tightening via the run-off of bonds from the Fed’s balance sheet, it looks like it will stop by the end of this year, as per Chairman Jerome Powell’s statements. It is amazing how $1.3 trillion in Treasury supply, courtesy of the Trump tax cuts combined with $500 billion run-off cap from the Fed’s balance sheet, cannot get the 10-year Treasury yield to even 3%. Long-term interest rates feel very heavy and if they cross 2% to the downside and the 2-10 spread finally inverts, they may not see 3% for many years.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There appears to be a “head-and-shoulders” top in the 10-year Treasury yield, to use trading terminology, which “broke” at 2.6%. The “head” is 3.25% so the gap measures 0.65%, or 65 bps. If the fascinating world of chartology is any indication, this chart says the 10-year note yield is headed to 1.95%, which is a heck of a lot weaker than most investors, including myself, expected at the beginning of the year.

Personally, I do not make decisions based on charts alone, but I have never met a futures trader that does not know how to read a chart. And there is a lot of futures trading going on in the Treasury market and the euro-dollar and fed funds market for that matter. They all say that the Fed is done. In my view this decline in 10-year note yields is much more due to a weak global economy than any issue with the United States.

The next time there is recession, I think the 10-year Treasury yield will likely break 1%, given the willingness of the U.S. central bank to engage in such unorthodox monetary policies. Based on the low level of unemployment in the U.S. and largely pro-growth White House economic policies, there is not going to be a recession in the U.S. this year, but when it comes to 2020 and 2021, a lot can change.

Fed “On-Hold” Beneficiaries

In theory, this sharp decline in global bond yields catalyzed by the Fed being “on hold” and weak data in Europe and China should be bullish for gold bullion and emerging markets, as is often the case when Fed tightening cycles end. In theory an end of Fed tightening should be bearish for the dollar but not this time.

I think the dollar has more upside because the euro and the Chinese yuan have more downside. The ECB is proceeding with more QE, which is euro-bearish, and coupled with the epic Brexit disaster is bound to push the euro lower. By the end of the euro weakening cycle, it is conceivable that the euro falls below parity (1:1) to the dollar. The interest rate differentials are dramatically in favor of the U.S. dollar, and while the Fed is in QT mode, the ECB is in QE mode. Parity is only a matter of time in such a scenario.

The Chinese yuan, on the other hand, is not part of the U.S. Dollar Index. Still, China is in a very sharp slowdown, which is catalyzed (but not caused) by tariffs and trade friction. Because of the deflationary nature of too much debt in the Chinese financial system, it is entirely plausible that the People’s Bank of China (PBOC) decides to devalue the yuan, as it did in December 1993, when they did so to the tune of -34%. At the time, there was a sharp recession in China that was not officially acknowledged, but it showed up in secondary (i.e., undoctored) banking loan-loss data.

In the year 2019, there is much more at stake as the Chinese economy is nearly 20 times larger than it was in 1993 and its level of indebtedness is at least four-fold higher, causing a sharp economic slowdown to carry the high likelihood of a hard economic landing. The jury is still out if the present sharp slowdown ends up like a Second Asian Crisis, but there is no doubt in my mind that this is where China is headed.

The loan quotas and injections of more liquidity in the Chinese financial system are tools that have allowed the Chinese government to prolong their economic expansion for over 25 years. Those same tools will be the very reasons that make the hard landing a lot worse, since they have resulted in a massive credit bubble. So if someone is waiting to see the emerging markets outperform – or for the U.S. dollar to go down – it could be a very long wait.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*

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