Yield curve under siege?

In the last couple of weeks we have witnessed a dramatic change in the shape of the U.S. yield curve which has shifted from being inverted to upward sloping. In previous cycles, an inverted yield curve was an almost perfect predictor of an impeding recession, but this time around, despite the slowdown in the U.S., a full blown recession is unlikely (although a fat tail event that would trigger the "great unwind" is not altogether impossible). Again, we can credit the paradigm shift for the shape of the yield curve, the recent sell off in the fixed income market reflects growing concerns on global growth and the rising risk of inflation. Normally, the yield curve should reflect the health of the local economy (especially in the U.S. which still commands the largest economy in the world), but instead what we are seeing here is a yield curve that is moving in sync with others so that it can remain competitive (not surprising considering that the U.S. is a net debtor nation and imports significantly more than it exports). The worry here is that if the yield curve continues rising, it could precipitate the slowdown by introducing further strains into the already battered housing market, make it more expensive for businesses to borrow and apply the breaks on the bustling LBO activity. With the amount of unquantifiable leverage circulating, a catastrophic "great unwind" could well be within reach.

Another perfect storm?

The surprise Kiwi tightening coming on the wake of the ECB rate hike triggered a sell off in fixed income markets as investors embraced themselves for the potential of additional hikes reflecting the strength in the global expansion and a rising risk for inflation. Markets were palpably nervous with the changing environment, leading to a jump in the volatility index (similar in impact to the Chinese triggered global stock market sell off at the end of February) and a drop in stock markets. Rising bond yields and a resulting shift in their relative attractiveness was another factor behind the sell off in equities. In the U.S., signs of a pick up in economic activity and better than expected trade balance figures were additional contributing factors that helped push the 10 year benchmark yield above the 5% psychological barrier. One clear impact of the rise in yields is it's corrosive effect on the yen and the Swiss franc resulting from the growing attractiveness of the carry trade.

Housing slump expected to drag on...

According to comments made by Bernanke, the sub prime debacle will continue to drag the economy for some time to come as a result of the "knee jerk" reaction of more restrictive lending policies for this segment. Indeed, there has been a strong drop in new construction and building permits lately. There is also a risk that this overflows into other segments. If we also take into consideration that the most recent core inflation figures remain above the 1 to 2% comfort zone, it effectively means that we will not be seeing any Fed interest rate action for a while, possibly not until early next year. One scenario (the most ideal one for the Fed) is that the slowdown is enough on its own to drag the core rate below 2% so that the Fed can shift from a tightening to a loosening bias and focus on employment. Apart from the housing market, capex and consumption are showing signs of weakness. On the other hand the weaker dollar and strong global expansion are factors that counter the drag on U.S. growth. The next few weeks and months should provide us with a better idea on which of the two counter forces end up dominating.

The housing market and beyond...

Although we saw the large pickup in U.S. new home sales for April, the ensuing figures on existing home sales were clearly less stellar. The short term boost in new home sales reflects a relatively strong economy and comes as builders have been aggressively cutting prices to stimulate demand. The sub prime debacle is unlikely to go away any time soon considering that more than three quarters of mortgages were negotiated on adjustable rates which means that borrowers will sooner of later have to pay higher monthly rates, raising the likelihood of further bankruptcies.
Japan, another economy in crossroads, has had more positive news lately with the unemployment rate dropping to a record 3.8% (second lowest amongst developed nations) and sings that consumption is picking up. This bodes well for the BOJ that are itching for a reason to hike rates further. Wages are not expected to pick up dramatically, however, as the ageing and more expensive pool of retirees are being replaced by younger and cheaper graduates.

A black swan in our midst?

A series of related factors have led to what seems to be a permanent change in the global economic landscape. The ideological shift towards liberalism at the end of the 80's resulted in the release of a huge supply of untapped cheap and in some cases skilled labor, prompting firms in developed nations to increasingly relocate production to new emerging players, leading to a long term boost in profit margins that continue to exhibit a surprising degree of resilience to the vagaries of the markets. Tapping into this new supply of cheap labor combined with improvements in inflation targeting and coordination by central banks also explains to a certain extent why inflation has remained relatively tamed despite cyclical and exogenous pressures. Technological leaps in communications such as the advent of the internet in an environment of successive deregulation, the gradual dissolution of trade barriers and dramatic improvements in capital flows have been conducive in providing an almost limitless source of liquidity coming from emerging nations with large savings towards debtor nations such as the U.S. The rapidly changing landscape has also led to an explosion in financial innovations providing greater access to capital and improved risk control. This is not to say that the risk to economic growth in this new environment has been reduced or eliminated altogether. Trade imbalances in both capital and goods continue to widen whilst the average U.S. consumer's spending habits are increasingly challenged by rising fuel prices, a weakening dollar and the ongoing housing debacle.

Steering in fog

If we look at last week's PPI figures and today's CPI results, inflation fears should be receding. The Fed has made its position clear by stating that although its policy retains an inflation bias, it is well aware that the economy is slowing down and is hoping that this will be sufficient to contain inflation. It is a tricky game because the other statistic that the Fed is particularly sensitive to is unemployment, and recent figures paint a deteriorating picture on this front. As we mentioned earlier, in the current environment, Fed policy is at crossroads. On the one hand, they can't really tighten any further as the economic slowdown continues to unravel. On the other hand, they can't loosen as long as core inflation is above the 2% upper limit of their comfort zone. With gasoline prices where they are and as the housing slump continues to take it's toll combined with a deterioration in employment, household consumption is set to drop further. This will be partially offset by the export effects of a weaker dollar and a global expansion that is in better shape. We could also add to this a pick up in capital spending but it is still premature to consider this as a given.

Stuck at crossroads...

The Fed reiterated its wait and see approach to rates, emphasizing the fact that although they expect a moderate recovery for the third and fourth quarters, their main concern remains inflation (most recently at 2.1%) clearly above what it considers to be its comfort range of 1-2%. Yesterday's statement was in part geared towards providing greater clarity to the confusion over earlier remarks in which they dropped any mention of a tightening bias which the markets misinterpreted as meaning that inflation was no longer a central issue. Economic indicators are increasingly suggesting that the U.S. expansion is slowing down as the housing debacle, rising unemployment and higher fuel prices take their toll on consumption. The Fed is clearly betting on this slump to bring down the inflation rate which explains why they are unlikely to intervene anytime soon.

A more vibrant France?

As Sarkozy gets prepared to swear in as the 6th president of the 5th republic, one thought on the mind of many is whether he will succeed in pushing the country through much needed reforms by aligning France closer to the revered anglo saxon models of the U.S. and the U.K. The shortcomings of France's form of socialism have been particularly felt in the last decade with globalization taking a heavy toll on an archaic and highly inefficient system based on generous state subsidies and a particularly rigid labor market. If France is serious about competing in the 21st century world order, it will have to change its ways and it seems that the population is ready to embrace this change. Whether he succeeds or not is another story but what happened yesterday signals end of an era for socialism and a new beginning in which true reforms have a chance to see the light of day.