The Gap Between the 2-Year and 10-Year Spread Smallest Since 2007. Should You Freak Out?

One of the best predictors of future economic performance is the spread between the bond yields of different maturities. In simple terms, look at the difference between 10-year Treasuries and 2-year Treasuries, or 5-year Treasuries and 30-year treasuries.

Generally speaking, if the gap is rising, the yield curve is steepening. That’s a bullish sign for investors and the economy. If the gap is shrinking? Well, watch out.

The spread between the 2-year and 10-year US Treasury yields is at its lowest point since 2007, right before the financial crisis. The yield curve is flattening, which could be a sign that economic growth is slowing.

As the chart above shows, when the spread between the 2- and 10-year Treasuries narrows toward 0 percent, GDP growth slows a few quarters later. It happened in 2000-2001, as the yield curve actually inverted and the economy contracted. It happened in 2007, which preceded the Great Recession. The spread has narrowing for nearly 3 years, but is it now at a critical level?

Not only that, but the gap between the 2-year and 10-year US Treasuries has fallen for 8 straight days (as of November 8th – some of the daily changes in the chart below are negative, though near zero). What do investors see that is causing the yield curve so quickly?

Cart, Horse.

The gap between the 2-year and 10-year yields is 0.68 percent. That’s worrying. But it’s not a guarantee of recession.

First, there really isn’t any catalyst to the flattening yield curve. If anything, things seem calmer than they were just a few months ago. The fire-and-fury Trump statements have subsided (especially while on the Asian continent). The VIX – or the market fear index – is still below 10. Corporate earnings have come in above expectations. Things seem to be humming along. The bond market alone seems to be flashing a signal that isn’t mirrored in the rest of the markets and the economy.

Second, there have been large foreign purchases of US Treasuries in recent months. According to Bloomberg, China purchased more US debt in August (the most recent month available) than any month since July 2016. More foreign inflows would likely suppress yields. If the purchases are heavily weighted in longer-term debt, that would cause the spread to narrow. Indeed, the 10-year yield has been relatively flat, while the 2-year has trended upward. Foreign investors might be buying enough longer-dated debt to keep those yields relatively low.

The Noisy Calm

There is no smoking gun here. The mechanics of the bond markets are obfuscating what is really happening. But perhaps that is the reason to worry. Bond investors are often called the smartest people in the markets. Things might not be as calm and complacent as we expect.

Britain Wants A Post-Brexit Trade Policy. Why Not Join NAFTA or TPP?

Theresa May is having a difficult time laying the groundwork for Britain’s March 2019 post-Brexit reality. One of the Prime Minister’s greatest sources of frustration is how to manage trade after the UK leaves the EU. Without a trade agreement in place with its biggest trading partner, British industry and consumers will be hurt by higher tariffs and more frictions in exchanging goods and services.

[su_box title=” ” title_color=”#ffffff”]Read more about Theresa May’s Excellent British Adventure here: What Looms Large Over Theresa May? Seemingly Everything[/su_box]

According to Reuters, Theresa May’s government will submit legislation to shape its post-Brexit trade agenda this week. Liam Fox, the trade minister has an optimistic take on the situation:

“For the first time in over 40 years the UK will be able to shape our own trade and investment agenda – and we are determined that businesses and consumers can take advantage of this opportunity.”

Saying that existing trade agreements with the EU will be converted into UK trade agreements is easier said than done – just look at Theresa May’s current negotiations with the EU, or the contentious NAFTA talks that are ongoing. But at least May’s Britain is laying the post-Brexit groundwork.

Singapore on the Thames? Not so fast.

There are some challenges. Namely, so much of Britain’s trade is with the EU that there really is no replacement for what the UK currently has (or past March 2019, what the UK once had).

According to Thomas Samson of the London School of Economics, “the EU accounted for 44 percent of UK exports and 53 percent of its imports.” Simply joining another trade bloc won’t do much to replace the commercial relationship Britain had with the continent.

That’s an irreplaceable chunk of trade. But there could be some big upsides to joining one of the existing trade deals. First, Britain will have to take a piecemeal approach to create numerous bilateral agreements. That could take years, and there’s a chance the deals struck are worse than the TPP/NAFTA alternatives.

Second, despite strong growth over recent years, the European continent is still bound to a slower growth future. Joining the TPP would anchor the British economy to the fastest growing region in the world. Joining NAFTA would align the British with North American countries that it has long felt closer to than continental Europe (not to mention, longer-term economic conditions looks better in Canada/the US/Mexico than in, say, Italy/Greece/Spain).

Politics: The barrier to a post-Brexit multilateral trade world

The biggest hurdle is convincing the British people that this would be a good idea. Immigration was the biggest driver of the Brexiters, but trade came in a close second. Could residents in the midlands and north be convinced of just swapping one trade union for another?

The odds of this happening are low. But for British politicians and an electorate who might want a mulligan on the Brexit vote, this is at least worth consideration.

 

Cover photo:  Matt Brown (Flickr Commons)

What Looms Large Over Theresa May? Seemingly Everything

Theresa May, the lead in tragic play that is Brexit negotiations, continues to be hit by a variety of challenges. Business, the future of the UK economy and a resurgent Labour party are all pressing on the Prime Minister.

Like King Lear, the Prime Ministership is proving to be a lot more maddening than expected.

To recap the current state of Brexit negotiations: In the latest round in Brussels, EU and British negotiators could not agree to an exit bill. This is the biggest sticking point before moving on to trade and transition talks. The future relationship between the two is perhaps the most consequential part of the ongoing negotiations, and both sides are certainly keeping the March 2019 deadline in mind.

[su_box title=” ” title_color=”#ffffff”]Read our commentary on October’s Brexit negotiations: Why a Brexit Deal Remains a Leap of Faith: Theresa May’s Big Week of Negotiations[/su_box]

On the divorce settlement, there is some good news and some bad news for Theresa May. The good news? It looks like Theresa May has accumulated the political support to write a big check to Brussels. According to The Times, the UK government may be willing to pay €60bn to the EU to break free of its financial obligations.

The bad news? Everything else seems to be crashing down on Theresa May at once, just as she sets to the stage to move the negotiations on to trade.

So in addition to the Brexit negotiations, what exactly is giving the Prime Minister heartburn?

Business

The uncertainty from the Brexit negotiations have companies in Britain scrambling for backup plans:

• According to the Telegraph, 60 percent of UK businesses will have a contingency plan in the case of a no-Brexit deal by March 2018. That would directly result in jobs moving across the English Channel.

• Reuters recently reported that 63 percent of EU-based companies are expected to move part of their supply chains out of the UK. That’s an increase from 44 percent just 6 months ago. That’s in spite of a weaker pound, which makes investment even more attractive for companies in the Eurozone.

• According to the Bank of England, the post-Brexit landscape isn’t one that is favorable for investment. According to Bloomberg, “The central bank predicts that investment will be about 20 percent lower now than it expected before the referendum in June 2016.”

The good news: If the divorce bill is finalized and a transition agreement can be made., 75 percent of those no-Brexit planning businesses will reverse course.

The Future of the British Economy

• A recent paper from Thomas Sampson of the London School of Economics, titled “Brexit: The Economics of International Disintegration,” presents a dire warning for the UK. According to Sampson, the costs of Brexit will equal 1 to 10 percent of UK per capita income.

• Sampson also calculates that “the EU accounted for 44 percent of UK exports and 53 percent of its imports.” If there are higher costs to trade with the EU, that could very well fall hardest on lower income Britons, who are generally the biggest beneficaries of cheaper goods imported from abroad.

• The UK is already seeing higher import costs from a drop in the value of the British pound. In the short-run, that effect would likely dissipate. But in the long-run the UK faces higher import costs and more expensive goods because manufacturers can’t specialize in production. All of those garments made in lower-wage Eurozone countries? They’ll either be hit with high tarriffs, or they’ll have to be made in the UK. That is a direct hit to the wallets of British consumers.

•  The impact of the pound and inflation have already influenced monetary policy. Mark Carney, the Governor of the Bank of England, led the central bank’s effort to raise interest rates last week to fight inflation. This is in the face of declining real wages in the UK economy, and higher rates could sink short-term economic growth.

• Gavin Jackson of the Financial Times notes the productivity issue vexing the Bank of England. He writes, “They have changed their minds because labour productivity growth has disappointed over the last decade. The UK produced no more in an hour of work in 2017 than it did in 2007, the OBR and the BoE now believe this is the new normal and we will not return to pre-crisis rates of growth.”

[su_box title=” ” title_color=”#ffffff”]Read more on the Bank of England’s dilemma: The UK Death Cross: Wage earners are feeling poorer thanks to inflation and Brexit uncertainty[/su_box]

Sexual Harassment Charges in May’s Cabinet and Tory party

• Last week, UK Defense Secretary Michael Fallon resigned after sexual harassment scandal.

• This week, Theresa May’s deputy Damian Green faced allegations of having pornography on his Parliament computer and other incidents of “inappropriate behaviour.” Another Tory, junior whip Chris Pincher, was also alleged to have exposed himself to a political activist 16 years ago.

Of course, this isn’t anything that directly impacts policy. But it only hurts the confidence that both Tories and the British public have in May’s leadership.

Jeremy Corbyn’s Labour Party

As mentioned above, businesses are grappling with long-term plans if there is no Brexit agreement. Interestingly – and surprisingly, given Corbyn’s own beliefs on the relationship between government and business – businesses are seeing Labour as the more reliable partner, and are cozying up with the party. As noted in the Oct. 25 Bloomberg Businessweek article “Business is Building Bridges to Labour,”

Even Shadow Chancellor of the Exchequer John McDonnell, who a few months ago was criticized by some in his own party for saying “there was a lot to learn” from Karl Marx’s Das Kapital, is being courted by, and himself seeking out, big business. Two lobbyists speaking on condition of anonymity say that access to McDonnell has become the top demand from their clients, which include global financial services firms as well as retail companies.

Clearly British businesses have sub-optimal choices in the UK these days. European cities like Paris and Frankfurt are only making bigger oeuvres to draw companies to the relative stability of the continent.

Is the Lady for Turning?

There are contingency plans, of course. Betting odds from the website Paddy Power imply:

• A 20 percent chance (4/1) the UK applies to rejoin the EU by 2027
• A 12 percent chance (7/1) another EU referendum is held before April 2019
• A 2 percent chance (50/1) Theresa May performs a Brexit U-Turn and announces the UK will remain

Cover Photo: The Noun Project

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Vida Comes At You Rápido: 5 Things That Happened in Catalonia Since Friday

On Friday, our Weekly Wrap described how some of the friction between Catalonia and Madrid was subsiding (Read last week’s Weekly Wrap here). But the news flow out of Spain is anything but calm. 

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Things have moved fast since then. What you need to know:

• Madrid calls for December elections. On Friday, Mariano Rajoy’s government removed Catalonian leader Carles Puigdemont from office after invoking Article 155. Madrid has said that elections for a new Catalonian government will be held on December 21st.

• Puigdemont seeks asylum in Brussels. The former Catalonian leader has fled to Belgium, where he seeks asylum. Had he stayed in Spain, he could have faced up to 30 years in prison.

• Separatists have lost momentum. Early predictions for the December elections call for a win for pro-Spanish parties. Puigdemont will form a government in exile, but the future is looking bleak for pro-independence Catalonians. According to Bloomberg, “A poll on Monday showed just 34 percent backed independence, even as 76 percent want an official referendum on Catalonia’s status to be allowed.”

• Madrid may have a short-term handle on the situation, but what happens next? Since the events of the past few weeks, Catalonians are more amenable to remaining part of Spain. However, there is still a lot of discontent with the relationship with Madrid. Catalonia has operated as an autonomous state, and its citizens and government have long wanted more autonomy from the central government. Even without a complete secession, this desire has not changed. As Leonid Bershidskhy noted in Bloomberg View, “[T]he bigger problem remains unresolved: Catalonia will be a source of instability until its people are satisfied with the region’s level of autonomy (not independence, whatever the hotheads might say). Fixing that is a job for more flexible leaders with more long-term thinking.

As always, what does the market think about this?

Simply put, investors are happy as the seas are calm.

• The Spanish 10-year yield is trading at 1.48 percent as of Monday (10:45 am ET). That’s the lowest level since September 9th.

• The spread between Spanish and German bonds is 1.12 percent. That’s the lowest level since September 19th.

• The IBEX 35, the main Spanish stock index, is trading at 10,513. If the market closes at this level, that would be the highest closing price since August 16th.

Takeaway: Investors like certainty – that’s why Spanish bonds and stocks are rallying today. But the long-term plan for Catalonia is still murky. The Catalonia independence story may be at a lull, but it’s far from over.

 

Cover photo: calafellvalo (Flickr Commons)

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The Decade-High 2-Year Treasury Yield Is Not the End of the Bond Bull Market

The 30-year bond bull market has been predicted dead many times. Though 2-year Treasury yields hit a decade high, this time probably isn’t any different.

The 2-Year Treasury yield jumped above 1.60 percent today. That’s the highest level since the fall of 2008. The rising yield is taken as a bullish sign of near-term economic prospects – investors are dumping low-yielding debt to jump into the stock market which continues to hit all-time highs.

Onward and upward with long Treasury yields. Looks like we may have to run the “Is this the end of the 35-year bull market” piece again… pic.twitter.com/yRqsWbrDYM

— John Authers (@johnauthers) October 25, 2017

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The inimitable John Authers comes at this with a bit of tongue-in-cheek. But the rise in the yield might not the harbinger of an boom that many would expect. Looking at the 2-year in comparison to the 10-year yield, short-term rates are rising much faster than long-term yields.

A falling spread between the 2-year and 10-year yields indicates a flattening yield curve. That’s typically taken as a sign of trouble. Granted, the 10-year yield has continued to rise, which still indicates a risk-on environment. If the yield curve were flattening because investors were buying long-dated bonds, sending yields lower, that would be a pretty clear warning signal. But the fact that investors are holding dearer 10-year Treasuries shows a certain amount of worry in the system.

Still, the falling spread between short- and long-term debt is worth watching.

Consumer Credit at All-Time High: What Does This Mean for the Fed Chair Race?

Consumer credit as a percent of disposable income is at an all-time high. What could the policies of John Taylor and Jerome Powell mean for consumers?

Americans have been tapping into credit at levels we’ve never seen before. Some of the faster growing types of credit, like credit cards and student loans, float with interest rates. This means that more Federal Reserve rate hikes could make it harder for households to pay off debt. However, we might not see a wave of defaults that we’d expect in these circumstances.

That’s according to Wells Fargo’s Chief Economist John Sivlia and analyst Harry Pershing. In a weekly interest rate research note released on October 25th (link here), Silvia and Pershing note that consumer credit is at an all-time high compared to disposable income. That would normally bring about fears of a coming crisis, as a wave of defaults could push the U.S. economy right back into recession.

However, the authors argue that the Fed will raise interest rates slower than incomes will rise. That would mean consumers would pay more on debt, but it would be less of a burden compared to incomes.

Household debt delinquencies have mostly been falling since the Financial Crisis of 2008-09. Even though consumers are taking on more debt as a percent of income, they are still paying it down and not defaulting. Steady economic growth and a continuously improving labor market are certainly making consumers feel better about their debt burdens. The only way we’d see a spike in defaults is if rates rise much faster than expected.

What does this mean for the Federal Reserve Chair race?

Jerome Powell and John Taylor are the front-runners at this point. Powell would represent a continuation of current Fed policy, while Taylor is a bit more of a wild card.

Taylor’s famous Taylor Rule formulates the proper level of Fed base interest rates. It currently stands at about 3.0 percent. This is sharply higher than the current level of 1.25 percent. A move this big would be a huge shock to consumers holding floating rate debt.

Not everyone is convinced a Taylor Fed would raise interest rates this much, though. Taylor recently argued that the economy could withstand a 3 percent growth rate without too much inflation (specifically, if tax cuts lead to GDP growth). That would be a reason to leave rates lower.

Yellen, on the other hand, thinks inflation will tick upward if a massive tax package is passed. She would likely opt to raise rates in this scenario. Countering prevailing opinion, rates could be higher in a Yellen/Powell Fed than a Taylor Fed.

Consumers have benefited from a steady and predictable economy over the past decade. A massive shift in monetary policy could be the trigger that upends this consumer confidence, which makes this Fed horse race so intriguing.

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