Two weeks ago, Deutsche Bank’s credit analyst Aleksandar Kocic explained that with the yield curve becoming increasingly flatter, the Fed has roughly two more rate hikes left before it loses control as the curve first flattens completely and eventually inverts, a precursor to virtually every historical recession. As the DB strategist explained, given where long rates are the “Fed appears overly hawkish – it has only two more hikes to go and, for volatility and risk premia to reprice higher, the gap has to widen. As it appears unlikely that the Fed will be cutting rates any time soon, the gap could widen only if the Long rates sell off.”
The problem – as observed here virtually every day for the past year – is that long rates have refused to sell off, and while they did move modestly higher last week in the US, other developed nations have seen even more flattening to compensate for the move in the US.
Fast forward to this weekend when Macquarie analyst Viktor Shvets picks up where Kocic left off, and points out that investors’ expectation of tax cuts and potentially deeper regulatory changes, combined with evidence that global reflationary cycle remains robust, have firmed Fed’s tightening expectations and moved US 10Y yields above its recent 2.2%-2.4% range. However, there was no corresponding move in either Bunds (down 10 bps to 0.4%) or JGBs, thus widening real yield differential against Bunds to ~150bps (vs. 125bps in Aug’17 and 100bps in Oct’16) and against JGB’s to ~65 bps (vs. ~50bps two months ago). “Not surprisingly, this led to at least partial reversion of recent DXY depreciation.”
The bigger problem is that despite some notable rates moves last week, these have been confined to the front end, which means that even as probability of the Fed’s tightening increased and the short end of the curve responded, the long end has not moved much, and hence the US yield curves continued to flatten.
Currently, the 2s10s is trading at 82bps (since ’08 it has almost never been below 80bps), compared to ~90-95 bps in Jul ’17 and 130bps in Dec ’16. The further out on the curve that one goes, the greater the flattening, with the 2s30s now at 133bps vs over 200bps in Dec ’16. There were also no material change in the inflationary break-even rates or expectations.
Here’s why this is a big problem. As Shvets lays it out for the nth time, in a conventionally recovering economy, tightening by CBs should move the entire curve up, indicating strengthening confidence and rising expectations. However, it is clear that while the short-end is responding to growing probability of tightening, the long end is assuming that rising rates instead of stimulating growth and confidence, would increase the chances of much more disinflationary outcomes further down the road. In fact, the more the Fed has tightened, the more the curve has flattened.
From a practical standpoint this means that while the short end is assuming that mixture of rate rises and liquidity withdrawal would result in higher cost of capital, the intermediate and long end of the curve assume that neither supply nor demand for capital can withstand higher cost of capital. And as we, Deutsche Bank, Bank of America and many others have pounded the table previously, and now so does Macquarie, “Both cannot be right. Flattening yield curves imply less liquidity and higher probability that consumption and investment would fall and savings rise.”
Adding to the confusion, the curve has flattened even as financial conditions remain abundantly, generously loose. An emerging paradox here is that even though CBs have signaled that over the next 12 months liquidity flows
would fall by more than 50% (vs US$2 trillion injected this year) and liquidity might turn negative by the start of 2019 as BofA once again warned last week…
… financial stress indicators remain at the easiest ever levels. This is true whether we look at St Louis Financial Stress Index…
… high yield, TED or OIS spreads. This validates, at least superficially, what Shvets claimed before, namely that “we are living in a world without risks“.
The declining risks amidst rising cost of money and potentially falling liquidity is only possible if private sector productivity is improving. Unfortunately, we do not see evidence to support it.
So what does all of the above mean? Well, as Kocic warned two weeks ago, and as Shvets explained now, unless the entire curve starts shifting up, it appears that we are still in a world where CBs cannot tighten or withdraw liquidity. This in turn leads to another circular problem: the longer the Fed avoids the moment of reintroducing risks, the greater the eventual crash will be, i.e. the Fed’s “nightmare scenario.” Or, as Shvetz puts it:
“There is of course a policy concern that persistence of low volatilities and high valuations are raising financial stability risks. While these concerns are legitimate, we can’t see how price discoveries or volatilities can be re-introduced, without a risk of significant asset value contractions that would bring forward economic volatilities that CBs are trying to avoid.”
In other words, for all the talk and posturing of tighter conditions and future rate hikes, Shvets believes that “central banks remain slaves of the system, and a pleasant Kondratieff autumn is likely to endure.” The alternative is the Fed losing control – something which is not allowed to happen, and is why stocks continue to hit all time highs – ushering in the very unpleasant “Kondratieff winter.”
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