Once Again, the Yield Curve Takes Centre Stage

Aug 16, 2019 | Nick Scholte


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That distortions are at play in the yield curve seems self evident; also, China/U.S. barbs and olive branches continue to be "traded"; Hong Kong

To my clients:

It was a down week for North American stock markets with the Canadian TSX falling 1.2%; the U.S. Dow Jones Index falling 1.5%; and the U.S. S&P 500 falling 1.0%.

Despite the overall weekly market returns (noted above) being well within the “normal” band, the weekly returns mask a much more volatile daily market driven by a number of noteworthy developments. Let’s get to it…

If you’ve read the business press this week, you’ll know that the 2-year to 10-year portion of the U.S. yield curve inverted. To date, there have been other iterations of yield curve inversion over other segments of the full 3-month to 30-year curve, but this particular portion tends to be most-followed by the main stream business press. To be sure, an inversion of the 2-year to 10-year portion of the yield curve has an eerie predictive capability in forecasting economic recession, so the development should not be dismissed easily. That said, there are a handful of caveats I’d take into account when assessing the development this time around:

1) There were massive amounts of non-traditional stimulus (aka: quantitative easing) injected into the economy following the 2008 financial crisis, and it is almost certain that these actions have had a distorting effect upon the yield curve. The nature and magnitude of the precise impact is a hotly debated topic within the financial management community, but I’ve seen no claims that there would have been no impact;

2) At last report, there is over $16 trillion in negative yielding government debt around the world. For example, the entire 3-month to 30-year portion of the German government bond market now delivers a negative yield (in other words, whether you choose 1-year, 10-year, or 30-year German government bonds, when your investment matures you will have “earned” a guaranteed loss of capital). When rates for government debt are pervasively negative elsewhere in the world, might it not drive greater demand for better returning government debt…. like U.S. bonds? All U.S. debt currently generates a positive return, and it would seem likely that investors worldwide are indeed attracted to these positive returns rather than negative return alternatives elsewhere. And, because of the inverse relationship between interest rates and price, when demand for bonds increases, the yield generated declines. This too is almost certainly impacting the shape of the U.S. yield curve (again, how and to what extent are open to debate);

3) As the strategists at PIMCO (the world’s largest bond fund managers) have noted, there are structural factors at work also. Per Joachin Fels, PIMCO’s Global Economic Advisor: “rising life expectancy increases desired savings… the resulting savings glut tends to push the “natural” rate of interest lower and lower” (Nick’s note: in other words, interest rates are being forced structurally lower owing to the increased demand of an aging global population for secure investments).

The above three factors are almost certainly at play in the present yield environment and, further, there is likely a significant degree of interplay amongst them. The exact impact is almost unknowable, but it should certainly temper the impulse to over-react to the inverted U.S. yield curve. This is particularly the case when it is noted that a) GDP growth in the U.S. remains decidedly positive; and b) no other major economic indicator that RBC tracks (we track 6 major indicators) outside of the yield curve is currently confirming the signal sent by the yield curve.

The above being said, had I not already reduced client equity weightings on three separate occasions (totaling about 15%) since October of last year, this week’s developments would likely have prompted me to do so. However, the previous reductions did indeed occur, and I consider client portfolios to be adequately positioned in the current environment.

One last note on yield curves – whatever rationalizations might be made as to “why” an inversion has occurred, the factual reality of a yield curve inversion becomes ever more damaging the longer it persists. This is because credit creation, the lifeblood of business and corporate financing the world over, is undermined. For example, banks borrow at the short end of the curve (think of the cash sitting in you chequing account) and lend at the long end (say in the form of a 10-year business loan). If a bank must pay more to borrow at the short end than it gets paid to lend at the long end, it doesn’t take a financial professional to determine there might not be a lot of incentive to do so. Per RBC: “(negative yield curves) erode profitability on new loans which either reduces the lender’s incentive to underwrite new loans, or prompts the lender to price loans at wider credit spreads (Nick’s note: i.e., higher rates) which can diminish the loan demand from borrowers.” All this is to say that if the yield curve inversion persists, or some of the other major economic indicators tracked by RBC begin to roll over in sympathy (not surprisingly, credit spreads like those just discussed in this paragraph, are one of the other major indicators we track), then further defensive measures in portfolios might be taken.

Moving on to the trade front, last week I reduced client equity for the third time this cycle owing to President Trump’s surprise announcement of 10% tariffs on the remaining Chinese goods not already covered by the existing set of 25% tariffs. Many of the goods covered by these new 10% tariffs are consumer goods. Then, this week, Trump announced that about half of these tariffs would be postponed until December 1st, ostensibly as a Christmas concession to retailers. Also this week China promised retaliation for the 10% tariffs, but later the same day said it would be open to further dialogue. Despite the unnerving back and forth, it must be remembered that this is indeed a negotiation, and “back and forth” is an inherent part of the process. I continue to believe these trade issues will be, at least, partially resolved before the next U.S. Presidential election, and likely sooner. Both sides would seem well motivated to do so. Any conclusive resolution to the conflict would see markets move very positively higher.

Lastly, the ongoing situation in Hong Kong is concerning. I’ve steadfastly maintained that geopolitical events, while almost always alarming in the short run, nearly always have little or no lasting economic impact… and markets tend to react and recover accordingly. It is for this reason that only rarely, and selectively, do I comment upon them. That said, an incursion by the Chinese into Hong Kong would likely be the greatest geopolitical shock of my career mostly because of the actors involved (the 9-11 attacks would be the only other comparable I can think of off-hand). The situation bears watching, but I find it difficult to imagine a Chinese leadership willing to make any type of “show of force” gambit with world memories of Tiananmen Square still vivid, if not fresh. Further, trade negotiations that already seem to be having an impact upon Chinese economic data, would surely be set an alarming setback and would absolutely be injurious to the Chinese cause.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Vice-President & Portfolio Manager
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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