BOSTON, Aug 14 (IFR) –
• 2s/10s Curve Inverts in Clash of Overseas versus Domestic
• Not a Move to Fade; Central Banks May Respond with More Distortions
• Chinese Data Come in Light, German GDP Weak, UK CPI Beats
• Mortgage Apps, Import Prices and Fed T-bill Purchase
Markets themselves are the story this morning, not any news of note. On the news front China’s Industrial Production rose by 4.8% in July versus +5.8% expected, while July Retail Sales also fell short, +7.6% versus +8.6% expected. Germany’s Q2 GDP came in as expected at -0.1% though it did remind all that the global manufacturing/trade economy remains mired in contraction. Rounding things out, UK CPI beat expectations at 2.1% y/y versus 1.9% expected. Aside from the data, China confirmed that they will be meeting with US trade negotiators as planned in September. Again, however, markets themselves are the story.
This morning sees a further flattening of yield curves globally. The UST 2s/10s curve inverted momentarily (last at +0.2 bps) which has the financial media sounding recession sirens. Certainly there is an increased probability of such as the global economy and particularly its manufacturing sectors continue to suffer under the trade and currency wars. Amid revived optimism that the US and China may achieve a trade deal, there is likely enough pipelined damage to the global economy that it will take some time for it to recover even with a trade agreement.
Keeping that in mind, the global sovereign markets are betting that global central banks will respond with more policy stimulus. It’s a race to and through the bottom (i.e., negative interest rates) that the bond markets are trying to get ahead of. What appears as clear is that these bond markets are valuing central banks’ large-scale asset purchases rather than rate cuts as the main bond market driver and especially as it pertains to the shape of the yield curve.
In this case it is all about supply and demand. There is a limited amount of global duration. Indeed, the long end of global sovereign markets comprise the least amount of securities outstanding in relation to any other sector of curve. Unlike the balance of the curve, the long end has no maturities above it that “roll” down the curve. As it concerns the treasury curve the long end cost of carry is nearly zero, whereas it costs roughly 50 bps a day to carry short paper in the 5-year on inward sector of the curve.
Much of the above though is nothing new. What is seen as new is the insidious nature and impact of global central bank large-scale sovereign bond purchases and move into negative funding rates. The purchases have effectively taken over $15 bn in marketable sovereigns off the market, a fair portion of which with desired duration, which has depleted an already scarcely supplied sector.
Consider as well that unlike the US, most other sovereigns have not been increasing their marketable issuance but rather staying relatively static. Germany has significantly reduced the amount of new issue paper it brings to market. Negative yields increasingly force investors out the curve to find any semblance of a positive yield. Again, buyers are coming into a lightly supplied and relatively illiquid sector of the curve.
The incongruity of it all is that markets expect more of the same. That is, further moves into negative central bank funding levels (especially the ECB) along with more large-scale buying of sovereigns. Is it any wonder why global yield curves are flattening so? Perhaps to be considered would be for Treasury to alter their debt issuance to provide what the market craves in duration (fewer T-bills and more 30-year bonds) and perhaps for the Fed to engage in an “operation twist” and sell duration off their balance sheet to buy short-term paper to help normalize the yield curve that is being so technically distorted.
For now the trade has taken on a life of its own. Yesterday it was bear-flattening and today it is bull-flattening as the financial media beats the recession drums after the 2s/10s curve inverted. Equities this morning are taking up the recession banner, lower by 1% to 2% in Europe and a bit less than 1% stateside. These are not market moves to fade, particularly in the waning days of August where market liquidity is poor and getting worse.
Today the Fed will begin its open-market reinvestment program of $20 bn in maturing and prepaid MBS proceeds (any amount pay downs greater than $20 bn will be reinvested in MBS paper) as they are slated to purchase $3.025 bn in T-bills (11:00 am). Note that the Fed make its purchases in maturity order (T-bills first and 30-years last) with these purchases to be followed by TIPS and FRN purchases. Note as well that per the Fed, “The amount of purchases in each sector will be approximately proportional to the 12-month average of the par amount of Treasury securities outstanding in each sector relative to the total amount outstanding across all sectors, measured at the end of July 2019.”
The tactical bias is that of a neutral range trader now that the market is in the illiquid end-of-summer period. Look for a 1.70% to 1.55% range in 10s. The strategic bias is long the WI 6-month bill from auction at 1.89%. The curve bias is in a WI 1-year/2-year spread from 21 bps (1.80% and 1.645%) on a yield adjusted basis and a 10s/30s flattener from 45.1 bps.
Today’s calendar started with the MBA’s weekly mortgage application activity indices at 07:00. With the plunge in yields, mortgage applications surged. This was led by a 36.9% increase in refinancing applications as new purchase applications rose by 1.9%.
The Bureau of Labor Statistics will release July data on import and export prices at 08:30, where the Reuters poll consensus calls for no change in either the import price index or the export price index. In June, the all commodities import price index fell 0.9% m/m, its first decline since December 2018 (-1.4% m/m). In the 12 months to June, however, that index fell 2.0%, its largest year-on-year drop in 34 months.
The nonfuel import price index, which many prefer as the core measure, fell by 0.3% m/m in both May and June. It rose in only one of the last eight months and from June 2018 to June 2019, the index was down 1.4%, the most benign trade inflation environment in three years. The export price index fell 0.7% m/m in June, its largest decline in seven months and bringing the year-on-year change down to -1.6%, the largest fall in 34 months.
At 10:00, the Atlanta Fed will publish its Business Inflation Expectations survey for August. In July’s survey, firms’ year-ahead inflation expectations were virtually unchanged at 1.9%, on average.
The Energy Information Administration will publish the Weekly Petroleum Status Report at 10:30. Energy analysts surveyed by Reuters expect market inventories of crude oil in the August 9 week declined by 2.57 million barrels (mmb), which would cancel their increase of 2.39 mmb in the prior week. That was the first build in crude oil inventories in eight weeks, where stocks had fallen in the August 2 week to their lowest level in 38 weeks.
There are no Fed events scheduled and no Treasury issuance activities are planned, however, Federal Home Loan Bank has a global bond issuance slot.