Date: July 12, 2018
U.S. Yield Curve to Invert in Mid-2019, Morgan Stanley Says
The Federal Reserve next March will probably map out an end to the contraction in its balance sheet, helping support longer-dated bond yields, which will drop below those on shorter-dated notes by the middle of 2019, according to Morgan Stanley. “Investors are underestimating the size of the SOMA portfolio” that will be needed to keep the benchmark overnight interest rate within the range targeted by the Fed, Morgan Stanley strategists including Sam Elprince wrote in a July 12 note. SOMA refers to the System Open Market Account, the Fed’s name for its pool of assets. The Fed started shrinking its balance sheet last October, unwinding the unprecedented quantitative easing launched during the financial crisis. The recent phenomenon of the effective federal reserve rate trading toward the upper end of the Fed’s target range has been a sign to some observers that liquidity may already be getting tight. Some Fed officials have called for a discussion about where to take the balance sheet, with the run-off scheduled to increase by $10 billion a month, to $50 billion, next quarter. Morgan Stanley’s team sees the Fed providing a detailed account of exchanges on the issue in minutes of its December 2018 meeting, expected in early January. In March, they predict an announcement on plans to end balance-sheet normalization in September 2019. The yield curve has been flattening almost continuously since early 2017 as the Fed kept raising rates, pushing up two-year yields, while 10-year yields rose by less. An inversion has preceded U.S. recessions in the past, and some Fed officials have expressed concern about that happening. Ten-year Treasuries now yield just 27 basis points more than two-year notes.
Powell’s Fed Faces a New Question About Inflation
Under the leadership of former chair Janet Yellen, the Federal Reserve successfully identified 2017’s slowdown in inflation as transitory. Now with tariffs threatening to accelerate inflation, the Fed faces the opposite question: Is faster inflation just another transitory phenomenon? If Yellen’s successor, Jerome Powell, can’t repeat her ability to distinguish between persistent and temporary inflationary forces, then expect the ride to get much bumpier, ending with either a recession or high inflation — or a combination of both. When inflation rates fell in 2017, the Fed adopted the view that the decline was transitory due in no small part to a drop in mobile-phone service costs. This position allowed central bankers to keep pushing up their target for the federal funds rate throughout the year. That bet paid off, as inflation rates rose as expected and hence the Fed did not overtighten. It was a good call on Yellen’s part. Now the Fed needs to make another good call. Tariffs threaten to push inflation rates higher than expected over the next year. Should the Fed view the increase as transitory or something more sinister? On the surface, the answer should be straightforward. While tariffs should be seen as a supply-side shock that drives prices higher while pushing output lower, they should result in a level shock to prices, leaving any increase in inflation rates as transitory. Hence, Powell should be able to look through tariffs and follow Yellen’s lead by holding steady with the existing plan for rate hikes. Moreover, if Powell does conclude a tariff-induced boost to inflation is transitory, he will be primed to meet any slowdown in the economy with a more dovish policy path than currently envisioned. This was my takeaway from the minutes of the June Federal Open Market Committee meeting, in which policy makers bemoaned anecdotal evidence that firms were placing investment projects on hold as a result of the trade disputes.
Greek Bonds Need to Say ‘Carpe Diem’
Greece is approaching the threshold of a full return to the club of stable European countries that can issue debt at will. It can take a big step in that direction by issuing bonds. Officials have perhaps realized this, and they’re gauging investor demand with a U.S. roadshow on their economy. Hopefully, they also realize that the current friendly market conditions don’t have to last. Yields on Greek bonds are right around their best levels this year. The terms resulting from the June 21 Eurogroup meeting are generous, with 8 billion euros ($9.4 billion) of extra cash and a 10-year extension on repaying its outstanding debt to the European Union. This paves the way for a smooth exit from its third bailout this summer. It now has a 24.1 billion-euro cash buffer, and any new bond deals would increase this further. S&P Global Ratings raised its sovereign grade to B+ as a result, and has signaled a further one-notch upgrade may come if the country’s finances continue to improve. So the direction of travel is good, and investors buying now will do so in the hope of future rating changes. A further prize awaits. The prospect of Greek debt qualifying at last for entry into the European Central Bank’s QE programs is finally in sight. As Greece’s credit rating is still well below investment grade, this will require the ECB to determine that its debt really is sustainable. What better way than a new bond deal to prove it? Investors could see this as an opportunity to get in before Greece makes its way into ECB heaven. One of the country’s largest companies, Hellenic Telecom, tested the waters by issuing a 400 million-euro four-year note on Wednesday. And it was a big success, with an order book exceeding 1.8 billion euros. The 2.45 percent yield is 30 basis points less than what investors were originally offered. The demand really is there for Greek debt.
China Braces for More Pain From the Trade War as Economy Slows
Further evidence of Donald Trump’s trade war with China is set to show up in economic data due over the next few days, although it will likely just be a taste of things to come. From exporters of Wi-Fi equipment to households splurging on Maine lobsters and other American goods, China is beginning to adjust to the effect of the current tariffs from both nations, and the possibility of more. Hints at what’s happening will come in June’s trade data on Friday and second quarter gross-domestic product figures due on Monday. The trade war arrives as the economy is already slowing, adding an external shock to a home-made one. President Xi Jinping may ultimately have to choose between softening his multi-year campaign to control debt levels, or letting growth slow below the target of 6.5 percent. “There appear to be some risks to the 6.5 percent target, but the government is still committed to it,” said Chang Jian, chief China economist at Barclays Plc in Hong Kong. “As the trade tensions escalate and the data shows more signs of weakness, there will be more policy support and we should see some stabilization.” The impact is forecast to be moderate for now, with the median estimate of economists for output growth at 6.5 percent this year, in line with the goal. There might even be a temporary boost to second quarter data, as exporters may have attempted to sell more before the imposition of tariffs. The world’s second largest economy may have expanded 6.7 percent in the second quarter, according to economists Bloomberg surveyed ahead of next week’s data. That’s just a little slower than the 6.8 percent gain in the first three months of the year. Exports probably grew a healthy 9.5 percent from a year earlier in June, before the two nations started to levy an additional 25 percent tariff on more than $30 billion in goods. Adding duties on another $200 billion in imports from China could meaningfully increase the effect of the trade war. An early gauge of export orders at Chinese factories already tumbled into contraction last month, and a full-blown global trade war would shave 0.4 percentage point off world growth, according to Bloomberg Economics.