On Tuesday, December 4, the S&P500 fell by 3.25%, following an equity market swoon in Asia, as investors struggled to make sense of the US-China trade deal. This comes after a 6% rally in the S&P500 over the preceding six days, when it had seemed all was sweetness and light between presidents Donald Trump and Xi Jinping.
But suddenly investors are worrying they had misread the signals – and not just about trade. They are also concerned that falling long-term US treasury yields and a flattening yield curve are harbingers of recession in 2019 or 2020.
For our part, Euromoney isn’t sure these are the right things to worry about.
When we were young, this was the kind of volatility you saw in illiquid emerging markets that made you question the validity of any mark-to-market pricing. Rather than worrying about what ‘Tariff man’ tweets next, it would seem to us a better question for investors to ask is: By what possible definition the developed equity markets still count as an appropriate venue for allocating their funds?
Place your bets
Instead of weighing up the prospects for value over growth or industrials versus financials, they might be as well advised to take a view on the fifth horse in the sixth race at Ayr.
The obsession with the yield curve as a signal for the real economy also makes us wonder.
The spread between two-year and 10-year treasuries has fallen to its lowest in 11 years. The equivalent spread between three-years and five-years and between two-years and five-years has already gone slightly negative.
Head of the table: Xi Jinping and Donald Trump at the G20 summit in Buenos Aires on Saturday
Markets are worried because an inverted yield curve has predicted the last seven US recessions, albeit on nine occasions.
Untangling cause and effect in financial markets is a tricky business. Was it the yield curve inversion that triggered the equity sell-off? Does it even matter?
It seems sweet that the notion financial markets indicate anything about the real economy persists when the defining experience of this generation is that a crash in financial markets caused the last great recession.
Since then, policymakers have manipulated the life out of markets to repress debt service costs, encourage risk taking and eke out some inflation to maintain the illusion that repaying huge public-sector debts remains at least theoretically possible.
Of course, there are plenty of smart people in financial markets who can rationalize their way through all this.
We learn that two factors apparently give the CIO office of UBS wealth management comfort that the yield curve moves aren’t in fact signalling a worsening growth outlook.
“First, speculative short positions in long-maturity (around 20 years) Treasury bond futures are at their most extreme levels since 2010, meaning many investors were betting that long-end yields would rise. Short-covering likely contributed significantly to [December 4]’s yield decline.”
It’s always nice to hear about technicals versus fundamentals, just like it is about value versus growth.
Second, says UBS, while the two-year to 10-year portion of the yield curve did indeed invert prior to the last seven recessions, the lag from initial inversion to the start of the recession was over 24 months in the last two cycles. And this makes it “a flawed crystal ball”.
Euromoney is still wondering how on earth this is meant to be comforting and pondering traders’ versus investors’ time horizons, when the head of markets at one of the world’s biggest banks returns our call.
He tells us: “When the yield curve inverts, it has been a sign of the market expecting a recession not too far down the road. Now, there may be reasons to take this with a grain of salt. There may be technical factors at play. But the market is saying that it doesn't expect rates to stay high for long. I do wonder if the developed world is becoming like Japan, with real rates not likely to rise because growth remains slow, inflation restrained and savings high. It's what Larry Summers has been arguing for some time. This is secular."
Ahead of the curve
This makes sense to us. It’s not good of course. We were meant to have escaped this. It was fun for a while to talk about rates rising for the good reason of synchronized global growth and whether or not the Fed had got behind the curve on inflation. That would be a return to what those of us who came of age in the 1970s and 1980s think of as normal.
That the world has become Japan is a familiar idea. It is also a bleak one, because no one knows what to do about it.
All that is left is to worry whether or not some wrong move by central bankers to reduce their balance sheets could push us into quantitative tightening in over-valued and illiquid markets and trigger a financial crash that plunges the global economy into another recession.
Governments and central banks will have far fewer resources to pull us out with this time than they did 10 years ago.
Maybe Tariff man was right about the Fed.Now, what channel is the racing on?