It’s already been a big week for red flags in the bond market after the Fed’s most reliable recession indicator, an inversion in the US Treasury 3 month-10 year spread, led a rush to the safe havens of sovereign debt. See https://bit.ly/2BRqa4l . Yields are down everywhere, even hitting record lows in both Australia and New Zealand as negative effects of slowing growth and the US-China trade war intensifies and broadens. Globally almost $13 trillion of bonds now trade at a negative yield, meaning you have to pay the issuer for the privilege of owning them. Nuts, but a sign that investors are becoming more concerned with the return of capital rather than the return on capital. See https://bit.ly/2Wd91M1 .
The panic is starting to spread to the equity and credit sectors as two of the markets’ worst fears come into view. As we have noted repeatedly here, the possibility of 1) a higher dollar and/or 2) corporate credit downgrades remain the greatest threats for 2019 because of the destructive potential that both outcomes hold for a global financial system leveraged up on dollar debt. See “Rates Headed South for the Summer” and “Time to BBBe Careful“. These are the pain trades that central banks will find hard to mitigate and action in the bond markets is telling investors that they should indeed be worried.
One of the unintended consequences of the Fed’s policy over the last ten years was the explosion in USD-based borrowing and the inevitable deterioration in credit quality whenever easy money is on offer. While this is not exactly new news, half of the $5 trillion investment grade bond market is now rated BBB, just one step up from junk. (See https://on.mktw.net/2MaGX7m .) Even if you don’t know anything about finance that statistic should be alarming, and easy to imagine what happens when these borrowers start to get squeezed. The implications are enormous. The obvious threat to the markets from here is one which a combination of slower growth and tighter financial conditions imposed by international trade tensions, weak investment, and declining dollar liquidity triggers rating downgrades, forcing the selling of newly-relegated junk credit as it becomes ineligible for inclusion in investment grade bond indices. Investors would inevitably turn to more liquid equity markets to hedge exposure, creating a negative feedback loop (or “doom loop”) of risk reduction and lower prices across asset classes.
The downgrading of General Electric debt last October brought the issue of corporate debt into sharper focus and was a factor in the broad market selloff late in the year. The plight of the formerly-iconic blue-chip name is providing a preview of what could happen on a wider scale and we’d be foolish not to take heed. (See https://on.mktw.net/2wuGIcZ and https://cnb.cx/2FWFlI9 .) Dallas Fed president Robert Kaplan underscored this concern recently by saying that he’s more worried about businesses than consumers being the “front end” of the next economic downturn. He’s right.
The lasting impact of trade disruptions and a stronger dollar is still an unknown for macroeconomic and credit trends but almost certainly underappreciated is the sheer volume of investment grade debt perched on the edge of descent into junk. Credit spreads have widened in the past month as global growth slows, weighing on stocks and forcing investors into the safe haven of treasuries. The high-yield bond sector will be calling the tune that the markets dance to for the foreseeable future and ETFs like HYG or JNK are good benchmarks to keep tabs on the state of play in the sector. BBBe careful out there.
Economists are having a tough time figuring out why the market is pricing in potential rate cuts in the US while the economic data is so good. It’s a good question. GDP growth is above trend and the country is considered to be at full employment. Assuming all markets are equally forward-looking, it’s hard to reconcile the growing gloom in the rate complex against generally positive news flow on the economy and with equities posting record highs.
As of now, the front-end rate futures markets are discounting one rate cut for this year and one more in 2020. This implies a sense of trouble appearing on the horizon that could require a policy response. The Fed says that rate cuts are not in play but they’re not trying too hard to dissuade investors from arriving at that conclusion.
Part of the concern can be attributed simply to the age of the current economic expansion. These things don’t last forever. Absent a total collapse, by July this expansion will become the oldest on record at 121 months. That would be more than twice the average of 59 months for the prior 13 cycles.
Another explanation is the lack of inflationary pressure now playing a larger role in overall policy calculus. Something has gone wrong when trillions in stimulus don’t buy a sustainable inflation rate.
But a more interesting theory for the move in rates involves the growing probability of a much stronger US dollar, an outcome that could ultimately force the Fed to hold back its rise with looser monetary policy. Deep liquidity and a robust US economy make the dollar the most attractive currency on the world stage, but it is a double-edged sword.
It remains my opinion that a higher dollar poses an unknown and very underappreciated risk for the global macroeconomic condition, and not just as a general deflationary headwind. The leveraged exposure to the dollar created by years of borrowing against easy Fed policy by both sovereign and corporate entities is massive. And like other extremes caused by excessively profligate central bank policies, it’s truly unprecedented. We really don’t know what these actions have wrought and what the impact will be when the unintended consequences are eventually revealed. 2018 gave us a small taste of what happens when the dollar goes up: emerging markets and other vulnerable dollar-sensitive credits fall first, and then like dominoes end up knocking over the developed markets. It could happen again.
For now, the conundrum continues. As we have been witnessing since December (and for the past decade), the equity sector thrives on even the slightest prospect for easier Fed policy. The reasons why never seem to matter. Until they do. If I’m right about the dollar, signs of economic weakness and lower rates should not be taken as a benign development but rather as a warning.