To be clear, we normally wouldn’t pay much attention to what, ultimately, is a generic Bloomberg Op-Ed from Mohamed El-Erian, but it’s worth highlighting a couple of passages in the context of the macro narrative which dominated in Q4.
Yields of course plunged in August, when Donald Trump ratcheted up trade tensions with his “good friend” Xi, not because China had done anything wrong, but because the White House was irritated with Jerome Powell for not putting a dovish enough spin on the July rate cut. So, Trump figured he’d punish ol’ Jay by engineering a panic.
Between the growth scare catalyzed by the new tariff threat and the convexity flow pile-on, 10-year Treasury yields dove below 1.50% that month, inverting the 2s10s, a development Trump described as “CRAZY” in an infamous August 14 tweet that amounted to the president marveling at the sheer scope of the damage he had managed to do in the short space of two weeks.
In early September, yields snapped back, as the positioning squeeze and mechanical flow effect faded. At the same time, the Trump administration attempted a clean-up on the trade front, setting the stage for what, ultimately, would be the beginnings of a truce on October 11.
Over the course of the fourth quarter, yields rose steadily in anticipation of the “Phase One” deal announced on December 13.
The rise in yields off the August recession-scare lows served to trim the global stock of negative-yielding debt by more than $6 trillion. Generally speaking, this has been accompanied by a macro narrative that rests on two key pillars:
- The Sino-US trade deal will forestall further trade escalations, at least for the foreseeable future
- The dozens of rate cuts delivered by central banks in 2019 will begin to manifest in better economic outcomes as reflected in the incoming data
In addition to those pillars, reflation optimism has been bolstered by clarity on Brexit and the notion that one way or another (i.e., as part of a coordinated global effort or in piecemeal fashion on a country-by-country basis), fiscal stimulus is coming and with it, better growth, higher inflation and less pressure on monetary policy.
But how viable is that narrative? Both main pillars are shaky, that’s for sure. Donald Trump is notoriously mercurial and although there have indeed been signs of improvement in the macro, you could plausibly suggest that “improvement” is such a relative term right now that it’s all but meaningless.
Meanwhile, the dream of a concerted fiscal stimulus push meaningful enough to allow central banks to truly pass the baton remains just that – a dream.
That’s essentially what El-Erian argues. To wit, from a Bloomberg Op-Ed:
The recent fall in negative-yielding bonds indicates a promising handoff in market drivers that can push risk assets higher in 2020, if not beyond.
This is especially important for longer-term investors who tend to shy away from tactical investment positioning. It centers on the encouraging notion that the drop in negative-yielding bonds is due to prospects for higher global growth that will also develop stronger momentum because of greater fiscal stimulus — a development that would involve the long-delayed shift from liquidity support for markets to one based on fundamentals.
As much as I would like to buy wholeheartedly into this explanation, and as much as I remain upbeat about the market short term, the evidence for such longer-term optimism is far from overwhelming. For now, the pickup in global growth seems much more cyclical than secular and structural; and systemically important countries with fiscal room for meaningful budget stimulus, such as Germany, show little willingness to do so.
Is he right? Well, his skepticism is warranted, but it all depends on which data points you care to consult. We used the following chart last week to show the tentative inflection in manufacturing PMIs versus the reversal in the trend of negative-yielding debt:
Let’s look at the same chart, zooming in a bit and replacing PMIs with a few other key series, in this case German factory orders, South Korean exports and Japan exports:
Clearly, we’ll need to wait for the latest data from Germany and Japan (South Korea’s export figures for December were released on Wednesday and they did show a marked improvement, logging just a 5.2% contraction last month), but the point is simply that, for now, the phrase “we’re not out of the woods yet” is an understatement.
On the data we have right now, exports have fallen in Japan for a dozen straight months and in South Korea and Hong Kong for 13 straight months, while Germany remains mired in one of the deepest factory slumps in recent memory.
This underscores El-Erian’s concerns and those of others who, as we put it above, believe that “improvement” is such a relative term right now as to be nearly meaningless.
It could be that the reflation narrative has gotten ahead of itself, and the rise in yields is just a head fake. Or, perhaps, it’s the product of central banks signaling in unison that they intend to stand pat after 2019’s cuts barring a severe economic deceleration. As El-Erian puts it, “the gradual erosion in central banks’ appetite for the current negative-interest-rate regime is as important a reason as others for the decline in the pool of negative-yielding bonds”.
The worry, then, is that if central banks’ wariness about fostering still more perverse outcomes means the bar for additional accommodation is at least higher in 2020 than it was in 2019 (even if that bar is still far lower than the bar for tightening), a lack of real improvement in the fundamentals coupled with an insufficient fiscal response could leave investors twisting in the wind. Here’s El-Erian one more time:
While a large-scale retreat by central banks from ultra-low rates and accommodating balance sheet policies does not appear imminent, the bar is higher for another round of significant monetary policy loosening, especially when it comes to the extent of monetary stimulus in 2019. Indeed, without the type of a policy handoff that others and I have been writing about for a while — from excessive reliance on unconventional central bank measures to a more comprehensive pro-growth policy stance from governments — the risk will increase during 2020 that lower liquidity support for markets will not be sufficiently matched by improving fundamentals.
Draw your own conclusions.