Article / 12 February 2016 at 4:03 GMT

As yields collapse do we need to mention the 'R' word?

Managing Partner / Spotlight Group
United Kingdom
  • Ten-year yields are toying with 0%
  • There is blood in the water, which is breeding panic
  • It's not yet time to buy risk-on assets, but America will soon offer an opportunity
  • The risk of recession, is however, all too real in China and Europe

By Stephen Pope

The chart below illustrates just how far the yield to maturity on benchmark sovereign debt has declined since the end of 2015.

From this selection of large and liquid bond markets it is only Italy that has seen the yield to maturity increase. It says a great deal about the state of that nation. Italy has a debt to GDP ratio of 132.8% and the lack of structural reform. So rightly it is ignored given the fact that “Risk Off” has been the mantra to dominate trading in 2016.

If we interpret the path of these yields correctly and factor in the lack of confidence beginning to engulf sentiment toward the major central banks, then one has to wonder if the world is on a slippery slope toward a global recession.

Consider the case of the Eurozone, where the European Central Bank has dithered and delayed at every stage of conducting monetary policy and bank stress tests. The flight to the safety and sanctuary of the German Bund market is such that the average yield across the German yield curve, even if weighted by issue size, is now negative.

Think of it …

  • I am not just talking about the two-year debt that has been steadily negative since September 2, 2014.
  • The whole German sovereign debt structure with an average duration of 4.79 years (Source: OECD) would generate a loss for an investor if held until maturity.

I am all for believing in Germany’s credit worthiness, however, it comes to something when a passive investor actually has to pay up for the privilege of lending money for, on average, just under five years.

What about the nation that was the original source of quantitative easing i.e. Japan? As an individual security the 10-year Japanese Government Bond (JGB) carried a yield of 0.02% yesterday, and 0.27% on December 31, 2015. It actually did trade at a yield of zero on Tuesday. 

What does it say about our world if money that is invested for 10 years generates no return? It is not as if JGBs are scarce as the outstanding issuance stands at JPY 850 trillion or $132 billion. 

If yields were to creep higher, the Japanese banks would see their balance sheets under pressure as they are heavily exposed to any rise in JGB yields. The Economist calculated that a 1% increase in the yield from their current level would mean a loss of JPY 10 trillion for banks overall and would wipe out 35% of Tier 1 capital at regional and co-operative banks.

The drive toward a zero yield is of course a reflection of the negative interest rate policy that the Bank of Japan introduced after it announced the country’s first negative interest rate on Friday, January 29. The move, which was unexpected, shows the BoJ’s determination to combat economic headwinds that threaten to tip the Japanese economy back into a deflationary spiral.

Did the move simply illustrate that the BoJ, like many other central banks, has exhausted its options? After all the BoJ is already buying JPY 80 trillion (equal to $674bn) in assets a year. That step has placed 32% of the entire JGB market in its hands.

As in the rest of the world Japan has found that even with a major bond-buying exercise, the level of inflation expectations has started to wane. This year has certainly seen all major equity indices wipe billions of dollars off the value of market capitalisation.

 Time for new glasses? The rosy prognosis of a firmer global economy has been battered by what's happening in China. Photo: iStock

Should we be tearing up our 2016 outlook?

At Spotlight Ideas, just as at many other research units, this was meant to be the year where the global economy would enjoy firmer growth led by the US as cheap financing and low energy prices boosted the consumer’s ability to spend. However, that rosy prognosis has been badly battered as the alarm over the rate of deterioration in the Chinese economic outlook has undermined all assets except the traditional safe havens.

When the financial crisis was raging in 2009, there was talk of the new normal and as we looked for improvements in economic data it was not just the change in a variable (first derivative) but the rate of change (second derivative) that was seen as crucial.

Any indicator that was positive became a new life-raft to cling to. So similarly, as we are concerned over the risk of a slide into a new global recession should we not be looking at the second derivative of key economic metrics on the way down?

First and second differentials

I accept that this is just one metric, however, US nonfarm payrolls is a critical measure that the global financial community pays attention to. The figure that is released at 0830 Eastern on the first Friday each month is the “Change in NonFarm Payroll”, i.e. the first derivative or how much did the total nonFarm payroll change over one month.

In the chart below one will see in the orange rectangle that runs from October 2015 both derivatives are falling with the decline being greater for the second derivative. If the second derivative is positive, then the first derivative is increasing; on 70% of the observations that is the case.
Source: Bureau of Labor Statistics, Spotlight Ideas

Before one starts to panic look at the green rectangle that covers the period from April till September last year. The pace of decline in the two derivatives are identical and yet in that period there was no mention of a new global recession.

That was a fear during 2008, so how does the same data assessment look at that stage of our recent history?
Source: Bureau of Labor Statistics, Spotlight Ideas

What a contrast between the past 12 months and March 2008 to February 2009. Then when it felt the developed world was on its knees the change each month in the NonFarm Payrolls was so sharply negative that the second derivative that captured the rate of change almost flatlined as each month the decline expanded between 150,000 and 200,000 was left behind.

What is different now?

In stark relief the current situation in the US is that jobs are being created at an impressive pace and the level of unemployment is below 5.0%. The industrial base is relatively healthy as capacity utilisation is 76.5% – 67% at the depth of the 2008-09 crisis. Janet Yellen was totally correct to repeatedly remind the market of this fact.

Oil prices and indeed broad commodities are now falling. Of course in 2009 it was felt that the BRICS would pull the world along. Since then the doubts over China are well known and Brazil is failing to fulfil its potential and its debt is classified as junk. Russia is crippled by low oil prices and heavy sanctions. South Africa is held back by limited labour skills and weak infrastructure.

The Eurozone problems are scarcely better than they were then as Greece is still a basket case, Spain has no effective government despite it being nearly eight weeks since the election, and the French have no better handle on structural reform than do the Italians.

So do we use the “R” word?

Fed Chair Janet Yellen said on Wednesday that conditions have become less supportive to growth as foreign developments pose risks to the US economic outlook. However, she maintained that moderate expansion at home would justify gradual adjustments to the Fed's monetary policy stance.

She tried the same line on Thursday and yet investors remain unconvinced as US equities declined over the day while major European and Asian exchanges were off more than 2% in their Thursday trading sessions.

The Fed Funds contracts have completely unwound all the tightening prospects for 2016 that were present at year end. They pushed the interest rate expected in December below the effective rate calculated by the central bank.

In the US I do not sense another recession as in 2008 but the banking system is still risky. Eight years ago, swift and draconian action was taken by the Fed to clean up the banking balance sheet and the lenders are now better capitalised. 

The limited new lending that has been undertaken has mostly not followed the same ridiculous rabbit hole that was behind the subprime crisis. However, just as Japanese banks are heavily long of JGB so are US banks with skinny yield Treasuries. 

Start to factor in the exposure to bad energy-related loans and it is easy to become worried. However, capital is being set aside on a major scale and so I do not expect the US banking system to suffer the same indigestion as during the last crisis. 

Where there are troubles are with China and Europe. In the People’s Republic the government has increased debt on 28 occasions since 2000. The true picture about domestic growth can be seen by looking at the internal transportation of goods. A booming economy has an urgent need for physical materials to move from one place to another. The uncomfortable fact is that rail freight volumes are lower by 10.5% YoY – illustrating that China is not growing at the targeted 7% rate.

It is estimated that via the multiplier China accounted for 34% of global growth, as it slows so the knock-on effect for emerging markets is catastrophic.

Turning to Europe, the ECB ran bank stress tests that have on no less than three occasions been unfit for purpose. It is all but certain that another European banking crisis will be seen this year as the failure to confess to and remove non-performing loans will return to cast a long shadow. 

The ECB thought it had resolved the banking problem when it created the window of long-term repos that had no limit in size or time. The money was used to buy sovereign debt as against offering new, viable commercial loans. Hence on the tail of OMT the greatest skew and distortion of a bond market received another shot of opium. Add into the mix a central bank that is hallmarked by divided opinion and national agendas and it is most likely that whatever ECB President Mario Draghi unveils in March will be highly underwhelming.

  It is all but certain that another European banking crisis will be seen this year. Photo: iStock

The central banks are not out of ammunition just yet. In a recent note I did suggest that we could create a new paradigm and make the new monetary base permanent. We could have a coordinated programme of building sealed portfolios at each central bank of all the bad debt that still lurks on banks’ balance sheets. There needs to be series of private conversations and loan swaps between commercial and central banks.

I know that at the moment the pain is sharp and debilitating. Many of us even with years of market experience have been baffled by the year so far, but soon I expect the US equity market will offer a great buying opportunity … but avoid China and Europe at all costs. If the US will be Cinderella those two will be the ugly sisters.

– Edited by Gayle Bryant

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.


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