Plunging Yields Point to Rising Deflation Risk

Long Term Interest Rates Plunge to 2.9%

Despite the Federal Reserve’s (the Fed) policy of slowly raising rates to “Neutral”, the Bond Market won’t cooperate.  On Thursday, yields fell to a level that, not long ago, seemed UNTHINKABLE.

The Mini-Slideshow below illustrates the dramatic downward moves in 5 year, 10 year and 30 year maturities.  Especially troubling is the Long Bond which broke BELOW 3% and closed Thursday at 2.9%.  Since early November, the 5 Year Yield dropped 70 basis points (.70%), the 10 Year 75 basis points and 30 Year 55 basis points.

Friday’s “Moonshot” in Stocks produced slightly higher yields, but the Bellwether 30 year bond remained BELOW 3%.

The plunge in yields occurred DESPITE the Fed’s monthly SALES of Treasuries to unwind “Quantitative Easing” (QE).  From 2009 to 2015, the Fed aggressively purchased more than $3 Trillion in Treasuries and Mortgage Backed Bonds in order to add liquidity to the markets.  The portfolio is now being SOLD into the marketplace at $50 Billion per month.  For more background, please see “Christmas Crash (cont.)?” (https://markonomics101.com/2018/12/25/christmas-crash-cont/).

Plummeting yields are NOT a sign of a healthy economy.  Growth requires credit expansion.   Tumbling interest rates are a sign of weak credit demand, deflation, or both.    The odds that a MAJOR slowdown is imminent continues to rise.

The outsized move down in rates has formed a Yield Curve that is consistent with future economic contraction.   However, robust economic growth will INCREASE the odds of future interest rate hikes.

 

Yield Curve Contortions

The “Yield Curve”, on the left, is a snapshot of the relationship between yield and time-to-maturity for Treasury securities.  Typically, longer dated debt carries higher yields to compensate buyers for bearing the additional risk of time.  (https://www.zerohedge.com/news/2019-01-02/treasury-yields-tumble-11-mo-lows-amid-curve-inversion-chaos).

A normal yield curve is upwardly sloped, which reflects higher rates as time to maturity lengthens.  Not now.

Occasionally, short term rates EXCEED longer rates, especially during tightening cycles.  Known as an “Inverted Yield Curve”, it often precedes Recessions or economic slowdowns.

Inversion is most often measured as the difference between the yield on 10 year and 2 year maturities.  Today, that number is still slightly positive, but inversions exist below the yellow dashed line in the chart above.  The largest inversion is between the 1 year and 3 year maturities, approximately 15 basis points (.15%).

For a more thorough discussion about the implications of Inverted Yield Curves see: “Interest Rates In Sudden, Full Reverse”. (https://markonomics101.com/2018/12/02/interest-rates-in-sudden-full-reverse/).

Mixed Economic Signals

Economic data reports have been confusing.  Friday morning’s employment report was for a HUGE gain of 312,000 jobs in December.   (https://www.usatoday.com/story/money/2019/01/04/jobs-report-booming-312-000-were-added-last-month-economists-expected-181-000/2477547002/).  Employment, however, is a LAGGING indicator.

Christmas Retail Sales came in at $850 Billion, a solid gain of 5.1% from 2017.  (http://fortune.com/2018/12/26/us-retail-holiday-sales/).  Auto sales, on the other hand are poised to actually fall in 2019, according to Morgan Stanley. (https://www.zerohedge.com/news/2019-01-03/morgan-stanley-predicts-first-global-auto-sales-volume-drop-2009).  Both Tesla AND Ford reported very disappointing sales last week for the previous quarter.

Falling interest rates are NOT boosting pending new home sales, either.  Year-over-year, pending sales are down MORE than 5%. (https://wolfstreet.com/2018/12/28/us-housing-market-to-get-uglier-in-near-future/).

Economic data from around the WORLD suggests a GLOBAL SLOWDOWN.  European manufacturing is at 4 year lows.  (https://www.zerohedge.com/news/2019-01-04/eurozone-pmi-plunges-four-year-lows).  Chinese manufacturing data for December, just released, indicates CONTRACTION. (https://www.cnbc.com/2019/01/02/china-reports-december-caixin-manufacturing-purchasing-managers-index.html).

Even today’s employment report is a MIXED blessing.  Tighter labor market conditions were accompanied by rising wages.  On a year-over-year basis, wages are now increasing at 3%.  (https://www.zerohedge.com/news/2019-01-04/one-bad-thing-about-todays-jobs-report).

This suggests one of two outcomes:

  1. 1)  Increased inflationary pressure if companies CAN pass higher costs on to customers, or
  2. 2)  Falling corporate profit margins if they CAN’T

Profit Margins Are Historically High…..

 

 

The chart to the left is the historical ratio of after-tax corporate profits divided by Gross Domestic Product.  (https://fred.stlouisfed.org/graph/?g=1Pik).

Historically, profit margins range between 5-8%.  However, since the financial crisis of 2008-9, profit margins have been unusually elevated.  HIGHER labor costs and LOWER Corporate Profits has been the long run historical norm.

 

 

..At The Expense of Labor

While profit margins rose and Wall Street rejoiced, Main Street suffered.  The chart on the left compares the Growth in Corporate Profits versus in Employee Compensation. (https://fredblog.stlouisfed.org/2018/08/corporate-profits-versus-labor-income/).

Compensation, especially over the past decade, has substantially lagged Profits.  In fact, greater profits and margins WERE THE DIRECT RESULT OF lower employee compensation costs.

Following the Great Recession in 2008-9, persistently high UN-employment and UNDER-employment prevented real wages from keeping pace with profits.  So, apparently, did the outsourcing of manufacturing employment to countries like China and Mexico.

Historically, the share of Gross Domestic Product (GDP) represented by Corporate Profits versus Labor has been cyclical.  Compensation is far less variable than profits and tends to lag.   Main Street is Overdue to CATCH UP with Wall Street.  Or, conversely, Wall Street may be overdue to CATCH DOWN to Main Street.

Global Yield Curves in Deflation Chaos

The table below compares the Yield Curve of several countries with that of the United States.  Astonishingly, the United States has the highest yields among developed countries.   As such, it is the ONLY country that offers a REAL (yield net of inflation) return other than Italy.  

Most of Europe and Japan are mired in negative rates.  Will the US follow suit?

Country              CPI          3Mo. T-Bills         1 Year            2 Year            5 Year         10 Year            30 Year

USA                        2.2%               2.42%               2.57%            2.50%              2.50%          2.67%              2.98%

UK                           2.3%              0.72%                0.75%            0.74%             0.88%          1.27%              1.80%

Germany                1.7%                                         -0.59%          -0.65%            -0.31%          0.24%             0.86%

Italy                        1.1%                                                                  0.52%              1.90%          2.93%              3.67%

France                    1.6%                                         -0.57%          -0.45%             0.02%          0.72%              1.64%

Japan                     0.8%             -0.19%                                      -0.16%            -0.18%         -0.02%             0.66%

CPI for each country is latest 12 months.  Source: (https://tradingeconomics.com/country-list/inflation-rate?continent=g20).  Interest rates are care of CNBC. (https://www.cnbc.com).

Importing Deflation From China

China’s economy is now nearly 2/3rds the size of the US.  In 2005, it was only about 1/6th the US.  (https://www.bloomberg.com/graphics/2016-us-vs-china-economy/).

China’s middle class is thought to number 400 million out of the country’s 1.4 Billion people. Decades of population control have stopped population growth nearly dead in its tracks.  But, more importantly, the country has an aging population with a depleted pool of women in their reproductive years.

The chart on the left shows the deterioration of the Chinese consumer over the last decade through retail sales.  (https://www.zerohedge.com/news/2019-01-03/seven-charts-should-worry-anyone-following-apples-china-warning).

Apple warned investors that its revenues for the current quarter would DECLINE 5% from the prior year SOLELY as a result of a shortfall of I-Phone sales in China.  In a letter to investors, CEO Tim Cook also cited the Trade Wars and a slowing upgrade Cycle.  (https://www.apple.com/newsroom/2019/01/letter-from-tim-cook-to-apple-investors/).

If China is globally significant enough to cause such a huge “miss” at Apple, its deteriorating economy is now a MAJOR GLOBAL FORCE. 

For more information on the importance of Trade, please see: “Can Anyone Win A Trade War?” (https://markonomics101.com/2018/07/09/can-anyone-win-a-trade-war/).

Deflation has NEVER historically been associated with prosperity, but examples of it are rare.  Examples include The Great Depression, Japan’s “lost decade” (following the 1990 real estate collapse) and a severe depression in Russia (after the demise of the Soviet Union).

We continue to urge risk reduction and capital preservation in these incredibly volatile markets.  Be Informed, Not Misled!

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