Why You Must Watch the Yield Curve and China Closely

Why You Must Watch the Yield Curve and China Closely

The S&P 500 hit a new all-time high in US trade overnight. This suggests the US economy is still rollicking along.

But you wouldn’t know it if you take your cues from the yield curve. This measures the difference between the yields on two- and 10-year Treasury securities.

Right now, there are only 23 basis points between them. In other words, the curve is extremely flat.

Yet a roaring economy suggests long-term rates should be much higher.

Something doesn’t add up here.

Traditionally, when this curve ‘inverts’ — that is, short-term rates go above long-term ones — a recession is not far away.

We’re within a whisker of this happening.

This is not to say a recession is guaranteed, only that it becomes a higher-probability outcome based on historical data.

Perhaps more importantly, an inverted yield curve puts the banks in a difficult position as their short-term funding needs become more expensive than their longer-term assets.

Many people make the mistake of believing that central banks act to protect and enhance economies. In my view, that’s never the primary concern. The central bank is designed to protect the banks above all.

This leads one to the conclusion that the Fed is going to pause its short-term rate hikes.

Such an outcome could be disruptive to current expectations. Currently, data from the US futures industry has a record number of traders betting on higher interest rates, which they do by shorting Treasury futures.

Yet they could be in for a nasty surprise if long-term yields go down or, conversely, bond prices go up.

Jeff Gundlach, the ‘Bond God’, warns there could be a hefty short squeeze here if all these traders try to unwind their positions at the same time.

Suffice it to say, while there’s a lot of positive press around US stocks at the moment — with good reason — another panicky, sharp drop like we saw in February cannot be ruled out this year. And maybe even more than one!

My old mentor used to say that short, sharp selloffs — like the one in February this year — are typical bull market behaviour. If you’re a long-term investor, you can ride them out, even if they seem scary at the time.

We’ll know more on the outlook for interest rates when the latest Fed minutes are released later this week.

However, there’s also the perennial wildcard in the form of US President Donald Trump.

Why central bankers are more like rock stars

Trump is neither a fan of more interest rate increases nor the strengthening US dollar.

Don’t forget now that current Fed Chairman Jerome Powell is in the position thanks to Trump. The president declined to offer the former Chair Janet Yellen a second term in office.

Powell might feel the need — or pressure — to show his gratitude. That could lead to a suspension in rising interest rates.

Staying in the job is a powerful motivator. After all, it’s quite a gig being the Chairman of the Federal Reserve if you’re a power junkie, as most politicians and bureaucrats tend to be.

What stood out in reading former Chairman Ben Bernanke’s memories was the rock star treatment he received- private dining room, security detail, and first class world travel, among other things.

Not only that, there’s no doubt that the endless speaking fees and book deals that can come afterwards are a huge attraction.

Alan Greenspan was the second-longest-serving chairman in US history. He’s still advising clients today despite the setup for the real estate bubble that burst in 2008 happening mostly on his watch.

Speaking of property, Bloomberg reports that the China Banking and Insurance Regulatory Commission is looking at introducing reverse mortgages. This is when a homeowner gives up equity in their home in order to receive regular payments.

Bloomberg suggests that China has an enormous pool — numbering in the trillions of dollars — of untapped home equity wealth. Not only that, Chinese retirees and pension funds are facing massive funding shortages.

This bears close watching because it could unleash a huge turbocharge to Chinese consumption — a sector that’s already moving up at a heady clip.

And it bodes well for the global economy and the ongoing bull market in stocks.

Stay tuned for more on this.

Regards,

Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia