The big rally in ten-year Treasury bonds has created a worrying situation in the bond market—a steepening inversion. Despite the broad based rally, the negative spread between ten-years and three-month yields actually grew, as did the spread between two- and thirty-year bonds. Oil also plummeted 5%, as did the Dollar, a reflection of traders’ bets that the US is likely headed for a downturn and easier monetary policy.
FINSUM: The current inversion could just be a product of markets flows dictated by the trade war. What is worrying is that negative spreads actually widened instead of just staying flat, which adds more weight to the inversion-recession story.
China has a massive hoard of US Treasury bonds worth over $1.2 tn. Many have speculated that as part of a trade war with the US, Beijing may flood the market with these bonds in an effort to enforce pain on the US economy. Recent market data shows it is likely already happening. China recently dumped $20 bn of Treasuries, a move that cannot be accounted for as part of normal market flows. The move was China’s largest sale in more than two years. The sale came in March, just before US-China trade tensions were again heating up.
FINSUM: Our view is that China is more likely to threaten doing this and perhaps do some in small chunks than actually pull the trigger. However, even if they do, yields have fallen so far recently that it is hard to imagine they would rise much beyond where they were a few months ago.
The market shave been hoping, clinging, to the idea that the Fed will cut rates soon. Bond markets have all but assumed it with pricing, and even equities seem to favor the odds. However, the release of the most recent Fed minutes have all but put to bed those hopes. The notes clearly show that while the Fed is willing to leave rates where they are for some time, there is no appetite to cut.
FINSUM: One important caveat to these minutes is that the meeting was held just before the big blowup in US-China trade talks. At the time of the meeting, it looked like it would be smooth sailing to a deal.
There has been growing consternation about the threat of a major meltdown in corporate debt. The Fed, in particular, has been very troubled by the amount of corporate debt in the economy, which has led to speculation by Wall Street that there could be a blow up. Goldman Sachs has been more sanguine, saying debt levels look healthy. Now the Fed appears to be taking a more mild view as well. In a speech this week, Chairman Powell said that the comparison to pre-Crisis debt levels are not convincing. “Most importantly, the financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages.
FINSUM: Debt levels seems high, but profits are margins are good to. The question is what happens when the economy turns south. We are especially concerned about the BBB market.
China is beginning its retaliation against the US’ increasing intense trade policy. The country is unloading its holdings of US Treasuries at the fastest pace in two years alongside the big rupture with Washington over trade. Its US Treasury bond holdings are one of China’s arsenal of weapons to retaliate against the US’ tariff hikes. According to Deutsche Bank’s chief economist, “The sheer size of [China’s] reserves and that this is even becoming a conversation means the market should take it seriously”. The country owns $1.12 tn worth of Treasuries.
FINSUM: This is quite a risk for the US as someone would have to absorb all those sold assets, and if they flooded the market, it would cause major volatility and sharp yield rises.
Between the escalating trade war and weakening data, the economic outlook is darkening. Accordingly, the market is increasingly betting that the Fed will cut rates. The market is now pricing a 50%+ chance of a 25 bp rate cut by the end of the year. Additionally, the yield curve, which is once again inverted, is signaling future rate cuts.
FINSUM: If Trump keeps escalating the trade war with China, he will force the Fed to do exactly what he hopes—cut rates! Really though, the odds of a rate cut are rising as the trade war looks like an ever bigger headwind to growth.