A rallying stock market strikes a powerful chord with the public and politicians. Also important are government bond markets, led by US Treasuries and its 10-year benchmark yield. The current message in sovereign bond land represents a warning for equities while financial markets remain sensitive to the trade barbs and actions between Washington and Beijing.
The escalation of the trade war over the past week has duly rattled equities and, true to form, resulted in renewed falls in government bond yields for many leading economies. (See below.) A rally in the bond market entails higher prices and lower yields for any readers not familiar with fixed-income dynamics. In the chart below, one notable outlier in the sovereign rally stakes is Italy, illustrating how investors rank the country on the risk scale when a bigger scare erupts.
As equities in Europe and the US bounced on Tuesday, bond yields are barely reacting. The recent drop in top-tier bond yields reflects their status as a haven for investment portfolios, but another driver comes via falling expectations for inflation and the worry that trade friction will impair economic activity.
In the US the risk of such an outcome is shown by an implied rate of 2.08 per cent for the January 2020 Fed funds futures contract. A 25 basis point rate cut is priced into the market by the end of the year and, as Ian Lyngen at BMO Capital Markets, explains:
“It’s within the normal trading pattern for the Treasury market to price in cuts for several quarters while the Fed is on hold, even if the Committee is slow to deliver; so we’ll caution against fading what might ostensibly appear to be aggressive pricing of the probability of an ease.”
Looking at US inflation expectations for the next five and 10 years shows how the Federal Reserve is not seen meeting the 2 per cent target for its preferred measure of core consumer prices. Any boost in US inflation from higher tariffs is outweighed by a bond market focused on the hit to broad confidence from a more antagonistic relationship between the world’s two largest and most important economies.
Notably, the latest drop in US yields and inflation expectations began in mid-April, a time when trade negotiations were seemingly on course for a successful conclusion and equities were riding high. Bond traders have long cast doubt on the sunny view in which the second half of the year revealed an acceleration in the global economy and corporate earnings. That has been backed in turn by institutional flows out of equities for much of this year into bonds. Indeed, a 10-year Treasury note yield that this week dipped below 2.40 per cent is a far more striking development, given its low at the turn of the year after a prior bout of market stress was around 2.55 per cent.
The war of words between the US and China (that could well run until the G20 meeting at the end of June) has only helped affirm the trend of lower bond yields. In the past, this is a development that has helped limited losses for equities during bouts of turmoil (low bond yields are a barometer of easy central bank policy and that's the impetus for buying any dip in risk asset prices). As trade negotiations continue, it should become clearer whether bond yields are on the money and moreover if the global economy is in a far more vulnerable place than what global equities currently reflect.
Lower US yields also suggest the bond market is not expecting China to sell its vast holdings of Treasuries as a retaliatory measure. This link to the US Treasury website shows China tops the list of foreign holders at $1.13tn and that figure has only eased a touch over the past year. Hong Kong’s holdings have been steady around $200bn over the past year, while it’s unknown how much China holds in custody at other financial centres such as London and Brussels.
There is the prospect that some selling of Treasuries likely arises should the renminbi weaken towards Rmb7 per dollar. While a weaker currency helps offset the hit from tariffs, Beijing is wary of letting the Rmb slide abruptly (given the scale of collateral damage from such a development) and so will probably step in and defend that level as part of a managed depreciation.
Selling Treasuries to help defend a weaker Rmb will not mean that Beijing is escalating matters, although that won’t stop some from jumping to such a conclusion.
Over the long haul, Beijing has scope to shift away from US Treasuries, but at this juncture, they would only hurt themselves and the global financial system by selling a large amount of their holdings.
Alan Ruskin at Deutsche Bank says:
“The much more likely approach is a slow structural bleed in China’s US bond holdings, rather than a ‘dumping’. If China gets to the point of taking real actions to reduce US financial holdings, it is likely to come in baby steps to test out the water, rather than any quick rash decisions, not least because China will try to calibrate any global impact, and its rebounding impact on themselves.”
China also faces an asset allocation dilemma. US Treasuries stand apart from other assets in terms of their overall market size and liquidity, leaving China facing a tough time finding an alternative for their reserve management. The two main rivals to US Treasuries are Japanese government bonds and German Bunds. Both markets are negative yielding through to their respective 10-year benchmarks.
While China has been buying a lot more gold lately, Marc Chandler of Bannockburn Global Forex points out Beijing’s Treasury holdings are worth around five years of gold production (~3200 tons at $64m per ton).
That leaves China pursuing other avenues for applying pressure on the US in their tit-for-tat exchange over trade. Still, there is a broader recognition that over time China will seek to diversify away from US government bonds.
At TD Securities they think any meaningful drop in China’s Treasury holdings comes during the next US downturn. Much lower yields from here will leave China selling at the top in prices terms and into a market seeking more supply of US Treasury paper.
“We rather think that a move like this may make more sense in a US recession-like environment, where there is an inherent gravitational pull lower in yields from Fed policy (i.e. cuts) to counter the flow and minimize the valuation shock.”
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Quick Hits — What’s on the markets radar
Insurance counts for investors — That’s the message from the latest monthly survey of institutional investors by Bank of America, who note:
“Over one-third of investors surveyed have taken out protection against a sharp fall in equity markets over the next three months, the highest level in survey history.”
Michael Hartnett, the bank’s chief investment strategist adds: “Investors see little reason to ‘buy in May’ unless the 3Cs — credit, the consumer, and China — quickly surprise to the upside.”
Gold versus silver — Gold has drifted back under $1,300 an ounce on Tuesday and lately it has also been on a tear versus silver.
Marshall Gittler at ACLS Global notes the gold/silver ratio has climbed to its highest level since 1993 and while that suggests it’s time to buy silver and sell gold, he makes the following point:
“Gold tends to have more of a ‘haven’ appeal, while silver is used in commercial processes and so is more influenced by the economic cycle. As you can see, the ratio tends to rise during US recessions. So if the US-China trade spat does send the global economy into recession, we could expect gold to outperform silver.”
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