Pro Perspectives 8/14/19

August 14, 2019

Yesterday we looked the chart of the 10-year yield, which was disconnected from the brief risk-reprieve that came from the hope that was re-introduced into the trade dispute picture.   

As I said, the 10-year yield will be key to watch, for a guide on how far stocks can recovery without more progress made on the trade deal front.

Now we know.  It wasn't far.  

After some soft date in China overnight, and a GDP reading in Germany that confirmed a contraction last quarter, global bond yields took a dive.  German yields trade to new record lows (deeper into negative yield territory).  And the 2-year to 10-year U.S. yield curve inverted.  

This was news of the day, but there have been few things better telegraphed than a U.S. yield curve inversion.  The 3-month to 10-year yield curve has been inverted, for the most part, since May.  The chart below shows the 10-year yield minus the yield on the 3-month treasury bill …

When the 10-year is paying you less than you could earn holding a short term T-bill, the yield curve is said to be inverted.  And this dynamic has predicted the past seven recessions.  Why?  Because it typically will be driven by a tighter credit environment, namely banks become less enthused about borrowing in the form of short term loans, to lend that money out in longer term loans.  Money dries up. Unemployment goes up. Demand dries up. Economy dips.

So, are we seeing a tighter credit environment?  No. Below is the Fed's measure of financial conditions. 

Positive values (above the black line) indicate financial conditions that are tighter than average.  Negative values indicate financial conditions are looser than average.  Financial conditions are not a threat.

But we may see financial conditions tighten, if the stalemate on a trade deal continues for much longer.   We're seeing market sentiment beginning to crack. An erosion in confidence can ultimately spill over into economic activity. And that can and will tighten financial conditions.  

So, this uncertainty is all about trade.  Where do we stand on trade?  As of yesterday, Trump walked back on the magnitude of the September tariff escalation.  But today, Peter Navarro said they can't meet China half way.  As we've discussed, the longer this plays out the more leverage Trump loses to get any deal done (i.e. the more likely it is that China holds out through the election). 

Given the fragility in global markets, the timeline isn't working in the favor of Trump at the moment.  That puts the Fed in focus, as a potential Fed rate cut could provide some stability for markets.  With the next meeting scheduled for September 18th, I would say, if we have another day or two like today, an intermeeting cut is not out of the question. 

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