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Article / 04 July 2016 at 4:55 GMT

3 Numbers: Bond markets flash recession signs

Blogger / MoreLiver's Daily
  • Euro area Sentix investor confidence to give up last month’s outsized gains 
  • UK construction PPI expected to continue its decline, down close to zero growth
  • US 10-year minus 2-year yield spread to hit its lowest since financial crisis

By Juhani Huopainen

This is probably the week when the Brexit aftermath finally recedes and attention returns to the economic data and central banks’ policy responses. The key events of the week ahead are the release of the minutes of the Federal Reserve’s previous meeting on Wednesday and the US jobs report on Friday. 

Today is Independence Day in the US, which is a public holiday and financial markets are closed. Due to the lack of important data releases and the US holiday, trading during European hours should be quiet.

 US markets are closed for Independence Day but traders will be looking ahead
at this Friday's jobs report. Photo: iStock

Things should pick up tomorrow as European Union commissioners discuss the excessive deficits of Spain and Portugal. The Bank of England also releases the financial stability report and the UK Conservative Party begins selecting its next leader.

Today might be a good time to return to classical chart-based trading – EURUSD spent the last week grinding slowly higher, and is close enough to resistance at 1.12 to give an OK for trades probing the downside. Remember, expectations of a rate hike from the Federal Reserve went to basically zero after the Brexit vote. But now that it seems there was no “Lehman” moment – that is, a systemic financial shock – perhaps the Fed hawks will be back. Next Friday’s US jobs report could cause investors to get ahead of the game during the week.  

UK June Construction Purchasing Manager Index (0830) The barometer of construction activity has been declining since early 2014, and in May at 51.2 it reached a low not seen since June 2013. With uncertainty over Brexit, foreign asset purchases, asset price bubbles and long-term interest rates, such a decline from the extremely high levels was perhaps inevitable.

The index is expected to have kept declining in June, down to 50.5 – very close to the zero-growth 50-level.

Source: Saxo Bank

Now that the Brexit vote is over and long-term interest rates have taken yet another tumble, at least some of the uncertainty is now out of the way, and after a couple of months, activity could very well begin to pick again. During the 2013 slowdown – which lasted slightly less than a year – the index reached a low of 46.8. 

Depending on the speed of the policy response, perhaps the turnaround will this time be faster. Higher oil prices could also bring foreign buyers back to the market.

Euro area July Sentix Investor Confidence (0830). The Sentix investor survey in June showed a big improvement in economic growth expectations. The index jumped from 5.5 in May to 10.0, the highest level in six months. The Markit Purchasing Managers' Index or other comparable measures did not move in such a way, and one explanation could be that during the survey period the polls on the UK’s referendum were suggesting a relatively clear victory for the Remain camp.

 Source: Saxo Bank

 Source: Saxo Bank

US Treasury yield curve. Bond yields have collapsed in the aftermath of the UK referendum. The US 10-year Treasury bond yield was yielding around 1.7% right before the vote, but after the vote. it collapsed to a low below 1.4%.

US yield
Source: Saxo Bank

The 10-year yield has thus reached the July 2012 low of 1.381% – at that time it looked like the European Monetary Union would fall apart, until European Central Bank president Mario Draghi said the magic words: “whatever it takes”.

The two-year yield has also been decreasing a bit in recent months, as rate hike expectations have decreased.

The spread between the two rates, 10-year minus 2-year yield, has fallen below the low of 2012 and 2015. In fact, the spread is now at its lowest level since the financial crisis began. If the spread continues falling at its current rate, it would become negative in late 2017. Historically, the bond yield spread has been a good predictor of recessions. The lower the spread, the higher the risk of a recession.

US yield2
Source: Saxo Bank. Create your own charts with SaxoTrader; click here to learn more 

– Edited by Gayle Bryant

Juhani Huopainen is a blogger and a macro analyst at MoreLiver’s Daily. Follow Juhani or post your comment below to engage with Saxo Bank's social trading platform.


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