Over the past four decades and more, one reliable indicator has pointed to recession every time successfully and few years ahead. That indicators is the spread between short dated (2 year) and long dated (10 year) treasury yields.
The spread between 2-year and 10-year treasury yields dropped to just 95 basis points on friday, which is the lowest level since late 2007, eve of great recession.
Every time that spread has dropped to negative, recession followed. Last time it was in negative was back in 2006, which was followed by Great Recession of 2008, before that back in 1999, which followed dot com bubble burst and US recession of 2001.
Similar can be seen in prior recession too.
And biggest worries are, growth is already weak enough and central banks’ stimulus across globe at highest. There may be few tools left to Central banks’ arsenal to tackle such a situation and if triggers another global recession.
Greece still needs to find more than E1 billion in order to cover salary and pension payments it will face at the end of this month, an EU source has told MNI, after the cash-strapped government was forced to tap an emergency escrow account in order to meet a critical payment to the International Monetary Fund.
EU sources confirmed to MNI that Greece used a reserve account of Special Drawing Rights (SDR) to cover an E750 million IMF loan repayment due Tuesday. A Bank of Greece source said that the money in the account was available and unclaimed, and a last-minute solution was found to meet the IMF deadline. However, the funds need to be returned in a few weeks’ time.
“Greece right now has around E90 million only in reserves to pay wages and pensions in May,” which amount to around E1.2 billion, a senior EU source said.
“The quick fix of the SDR account just keeps the Greek government going without default but it now has to race against time to raise the money,” to meet its internal obligations. MNI reported Monday that the EU was getting increasingly worried whether Greece would made the payment after Prime Minister Alexis Tsipras informed the EU and the European Central Bank last week that he was unable to raise the amount.
High ranking EU sources have said that Commission President Jean-Claude Juncker and ECB President Mario Draghi were in constant contact with Athens to find the solution and that Draghi himself wanted to make sure that “things will stay in course.”
The government’s search for liquidity in lieu of the frozen E7.2 billion in bailout funds has included a drive to recover excess cash from local administrations and other public entities. As of Monday, the government said, its collected around E600 million, but a second senior Eurogroup source told MNI that any further cash collected raised from government organizations that haven’t handed in reserves would only cover a few more weeks of liquidity needs.
On Monday, while Eurogroup President Jeroen Dijsselbloem said he could not have a clear picture of the Greek liquidity situation, Finance Minister, Yiannis Varoufakis said “let’s not hide, liquidity is a terribly urgent issue.”
Both sources indicated that despite the positive statement on bailout talks by the Eurogroup Monday, key differences remain as neither side seems to be backing down from pension, labour and fiscal adjustments.
“The creditors will not back down because, first, the budget must be balanced which could mean further measures,” one official said. “Second, labour and pensions reforms are important,” he added, reiterating that there is still no clear picture on the Greek budget situation.
The second official commented that “both sides want a speedy solution, the climate in discussions is more positive and productive but no real breakthrough has been achieved.”
“We would wait to see in the following weeks, but so far as Mr Varoufakis said, the government remains firm to its position. But this is not possible,” the source said.
While some progress is said to be reached on issues such as non-performing loans on Greek bank balance sheets, privatizations and taxation, the talks could be stuck at any point when a difference of opinion emerges in the estimations of the fiscal situation, the sources said.
“Bigger gaps mean further measures,” the first source said wandering whether the Greek side will be able to accept it. “But liquidity is indeed running out so sooner or later we would have to come to a decision,” he added, mentioning that any extension of the programme is not realistic because it would mean that Greece will be able to cope through an extension without funds.
Sources have told MNI that if the two sides fail to agree in the next three weeks, the EU and the IMF are preparing a complete package proposal that will be presented to the Greek government with a “take-it-or-leave-it” ultimatum.
Greece’s banks hold enough eligible collateral to access an additional €14 billion in Emergency Liquidity Assistance funds, two Eurosystem sources have told MNI, suggesting that just weeks of increasing support remains for the country’s beleaguered financial system.
The total value of Greek banks’ eligible collateral after haircuts last week was about €93 billion, two Eurosystem sources confirmed, highlighting the limited scope for the ECB to further step up ELA support as political negations with the country’s international creditors drag on.
A return to the haircut schedule used late last year would shave €6 billion off post-haircut collateral, according to the sources, reducing it to about €87 billion and in turn limiting the scope for further ELA increases to just €8 billion.
The selloff in global bond markets over the past two weeks has investors wondering whether we have reached an inflection point in the extended period of ultra-low interest rates. With the Federal Open Market Committee (FOMC) creeping toward liftoff (still likely in September), eurozone inflation expectations stabilizing and the oil price creeping back up, it is tempting to argue that German 10-year yields near zero and U.S. yields below 2% were, in fact, overly stretched.
However, we remain skeptical of a sustained selloff at the long end of the yield curve. For one, coming out of a weak start to the year for the global economy, G4 monetary policy is poised to remain highly accommodative. Even at the vanguard in the U.S., the preconditions for Fed liftoff have not yet been met, and the FOMC is likely to emphasize that the upcoming pivot in policy will be gradual. Second, the market dynamics behind the recent upward repricing of inflation expectations will be tested as oil prices come under renewed pressure from stretched inventories. Finally, the fact that bond yields in the U.S. and Germany have tended to move in tandem in either direction (over the past month they have each increased by roughly 30 basis points) suggests that easy policy at the European Central Bank (ECB) will continue to weigh on U.S. rates once the current pullback abates.
That said, the selloff in bonds underscores the risk that fixed income markets will retreat hastily when the tide eventually turns. Our read of the moon phases is still at odds with an imminently rising tide, underpinning our modest duration overweight. We also note that at the short end of the yield curve the story is profoundly different. Even a relatively dovish denouement of the FOMC’s liftoff story is consistent with the front end of the yield curve selling off in the coming months, a flatter U.S .curve, and a re-firming of the dollar.
Running of the bond bulls. Bond yields across developed markets have shown a surprising sensitivity to economic data in recent weeks; surprising in the sense that there have not been any unambiguous indications of a broad-based acceleration in growth. Last week was no exception. More evidence emerged of first-quarter weakness in the U.S., and, while global output measures have not been as dour as GDP prints seem to suggest, global manufacturing output slowed in April.
Where the data does, in fact, suggest that the path of rates might be higher is in labor costs and inflation. In the U.S., lower productivity in the first quarter and rising compensation boosted unit labor costs, building on evidence from the Employment Cost Index that wages may be beginning to firm. Eurozone inflation data has also been slightly exceeding expectations, which has fuelled speculation about the expected length and intensity of the ECB’s quantitative easing program.
Signs of incipient inflationary pressure are also on display in market-based measures of inflation compensation. Five-year inflation expectations in five years time (5-year/5- year breakevens), the preferred measure of long-term inflation expectations at the Federal Reserve (Fed) and the ECB, hit 2015 highs last week at 2.25% and 1.82%, respectively.
An integral driver of the rise in inflation expectations is the recovery in oil prices. Brent and West Texas Intermediate (WTI) crude, at about USD 65 and USD 60 per barrel, respectively, are substantially higher than their troughs in January and March, flying in the face of a looming oil inventory glut and U.S. storage capacity reaching stressed levels. Petroleum data last week from the U.S. Energy Information Administration showed the first drawdown of inventories since the beginning of the year; however, the general trends of flat production and highly constrained exports remain intact.
The timing of oil price moves and the repricing of inflation expectations suggest that the two are closely related. The acceleration in crude oil price declines in October 2014 took place in tandem with the sharp drop in 5-year/5-year inflation breakevens. Symmetrically, the rebound in U.S. and eurozone inflation compensation that began at the end of April followed on the coattails of a bounce in WTI and Brent prices. If we are currently at the top end of the range for oil prices in the coming months, as many analysts posit, inflation expectations may well backtrack as this process goes into reverse.
Spillovers and automatic stabilizers. Even though labor market tightness and oil prices are not screaming that inflation will be higher in the near term, we are cognizant of the possible fallout from higher inflation expectations and benchmark rates. Given the low levels they were coming off, the percentage changes in European bond prices have been dramatic. In Spain and Italy, for example, the weekly price declines are on par with or lower than those in the depths of the eurozone sovereign debt crisis. Moves of this magnitude may also give rise to broader spillovers throughout portfolios as negative sentiment spreads to credit or investors cap losses in sovereign debt.
One force for stabilization is the response of monetary policy to higher rates. Were bond yields to continue to rise and begin to feed into tighter financial conditions, the implied path of policy rates in the coming years would implicitly become more shallow. That is, the FOMC would commit to an even more gradual path for the Fed Funds rate and the ECB might extend or even redouble its efforts. Lest we forget, the Fed also has a USD 4 trillion dollar balance sheet that will continue to weigh on long-term rates. An uptick in U.S. oil supply is an additional stabilizer that could emerge from the bounce in crude prices.
In sum, a common thread behind the backup in bond yields appears to be a repricing of inflation. The rebound in crude oil prices, an upswing in inflation compensation, and emerging signs of labor market tightness have sparked concerns that bond yields must rise. While we agree with the general prognosis—that rates are well below where they should be in the medium term—inflation will take some time to normalize from the current exceptionally low levels. That, and a likely dip in oil prices, suggests that bond yields are running ahead of themselves.
Chart of the week
Our Chart of the week shows the ascent of 10-year U.S. Treasury and German Bund yields since the beginning of April. The inflection points for both series towards the end of the month followed turning points in market-based measures of inflation expectations. A continuation of soft economic data or another dip in the oil price may quite possibly temper enthusiasm on inflation, which could moderate or even reverse this process.
Sources: Bloomberg, daily data, as at 7 May 2015