Markets moved into risk-off mode on Friday, after a much weaker German PMI survey increased concerns about the global economy. US equities were down sharply, more than reversing the gains seen in wake of the dovish FOMC meeting on Wednesday night. US bond yields moved significantly lower, and the 10 year Treasury yield fell below the 3 month rate for the first time since 2007, in a possible recessionary warning. The NZD was a bystander to the volatility in markets elsewhere, and was unchanged on the day.
The risk-on rally after the FOMC meeting last week didn’t last long, with a much weaker German Manufacturing PMI survey rattling markets on Friday. The German Manufacturing PMI fell to 44.7, its lowest level in six years, while the Euro-wide index fell by more than expected to 47.6 (a reading below 50 indicates contraction in activity). Respondents cited mainly external factors for the slowdown, including softer global demand and uncertainty around US-China trade and Brexit. On a more encouraging note, the Services PMIs were only slightly lower, and close to market expectations. The composite European PMI fell to 51.3, its lowest level since 2013, but still above the key 50 level for now.
The data raised fears that the European growth slow-down could morph into a recession. Several one-off factors held down European growth in the second half of last year, including a change to auto emissions standards which impacted German car production and low water levels in the Rhine which affected chemicals output. But the lack of a bounce-back in the PMIs this year has been striking. ECB President Draghi reportedly told EU leaders on Friday that there was “protracted weakness and pervasive uncertainty” in the Euro area economy but that probability of a recession was still “quite low”. The German IFO survey tonight will be closely watched.
Global bond yields fell sharply in the wake of the data, with the 10 year German bund yield falling 6bps to -0.015% (the first time it has traded in negative territory since 2016). The US 10 year Treasury yield fell 10bps to 2.44% amidst the weak German data, the sharp fall in equity markets, and signs of convexity hedging. The market now prices an 80% chance of a Fed rate cut by the end of this year and two full rate cuts by the end of 2020.
Adding to global growth fears, the yield spread between the 10 year Treasury yield and 3 month Treasury bill rate inverted for the first time since 2007, ending the session at -1.3bps. An inverted 3m10y curve has historically been an excellent leading indicator of US recessions; it has inverted before each recession since 1950 with one exception (in the mid-1960s). We make some comments about the yield curve and the risk of recession, for those interested readers, at the end of the note today.
The S&P500 fell 1.9%, more than erasing its gains in the aftermath of the FOMC meeting, with the financials sector among the biggest losers on the day (-2.8%). The VIX increased, albeit to a still-low level of 16.5.
In US economic data, the US services and manufacturing PMIs were weaker than expected (albeit both comfortably above 50) while existing home sales bounced back strongly. Market sentiment wasn’t helped by Trump’s announcement that he had nominated former campaign advisor, and vocal critic of the Fed, Stephen Moore to a vacant Fed Governor position. Moore has previously labelled the Fed as “the swamp” and blamed it for “economic mismanagement”. Moore’s influence on the committee, assuming he passes his Senate confirmation hearing, should be limited, given he is vastly outnumbered by conventional economic thinkers, but would be unwelcome distraction for the Fed and could create the perception of political interference in monetary policy.
The upshot of the fall in the stock market and increased growth concerns is that it might motivate Trump to press ahead with a trade deal with China. Trump told Fox News on Friday that “I think we’re getting very close” to a deal, although he cautioned “that doesn’t mean we get there”. US Trade Representative Lighthizer and Treasury Secretary Mnuchin visit Beijing this week to resume talks.
In FX markets, the EUR was hit hard by the PMI data, and ended the session at 1.13, down 0.6% on the day. The Japanese yen outperformed on the back of the risk-off sentiment in markets, rising 0.8% against the USD (USD/JPY ended the day below 110). The NZD traded a narrow 0.6865-0.6900 range on Friday, despite the marked increase in risk aversion, and ended the session unchanged at 0.6875.
The GBP recovered from its sharp losses on Thursday (+0.8% to 1.3210) after the EU agreed to an unconditional extension of Brexit to the 12th of April. That gives parliament a few more weeks to form a cross-party consensus on a way forward and the option of seeking a longer extension from the EU. Theresa May wrote to Conservative MPs on Friday and said she would only put her deal to a vote this week if there is sufficient support for it (which looks unlikely at this stage). An amendment will be put forward by several backbench MPs, including Tory MP Oliver Letwin, on Monday proposing that parliament holds so-called ‘indicative votes’ this week on possible options, which might include: revoking Article 50 and cancelling Brexit; another referendum; a customs union solution; EEA membership (a la Norway); a Canada-style free-trade agreement, and a no-deal exit. With a large majority of MPs against a no-deal outcome, and parliament likely to take steps to take control of the process this week, there is scope for the GBP to build on its gains from Friday. But with Theresa May coming under heavy political pressure to resign (UK media are reporting on a possible coup by cabinet ministers) and the tail risk of new elections, it’s still likely to be a bumpy ride.
In the domestic rates market, the NZ curve continued to flatten on Friday, with the 2 year swap up 0.75bps to 1.82% but the 10 year rate down 1.25bps to a fresh record low of 2.28%. The 10y NZGB yield closed below 2% for the first time on record. We’re likely to see a sizable fall in NZ swap rates when the market opens this morning, led by the long-end of the curve, due to the moves in global rates on Friday night. The focus of the domestic market is the RBNZ OCR Review on Wednesday, in which we expect the Bank to convey a similar message to the February MPS (i.e. the OCR is likely to be on hold for quite some time, and the next move could be up or down). Governor Adrian Orr speaks on Friday on the RBNZ new monetary policy framework, including the formation of a Monetary Policy Committee, which takes effect from the 1st of April.
As discussed previously, the US 3m10y spread has inverted. Does this mean the US economy is going to fall into recession later this year or next? We would make the following points:
1. The 3m10y yield curve is only very marginally inverted (by little more than 1bp). A deeper and more sustained period of inversion would be a more concerning warning signal on recessionary risk.
2. Relatedly, we note that the 3m10y curve inverted a few basis points for a short-lived period in 1998 and early-2006; in both cases recession followed, but only quite some time later (Q2 2001 and Q1 2008 respectively) and only after the 3m10y curve had subsequently moved deep into negative territory.
3. Some of the other commonly followed US yield curve measures are not negative. For instance, the 2s10s curve is positive, at 12bps. The signal from the 3m10y curve would be more powerful if were accompanied by an inversion in the 2s10s curve.
4. The 30 year bond has underperformed meaningfully on the US curve, such that the 5s30s curve is actually at its steepest levels since late 2017. If the market were really wary of an impending US recession, the 30 year bond has the most to gain, given it has the greatest duration and the highest yield on offer on the US curve. That the 30 year point has underperformed so much over recent months is another reason to be cautious about the signal coming from the 3m10y inversion.
5. There are several factors this time around that might be distorting the macroeconomic signal coming from the curve, including low and stable inflation expectations, forward guidance from the Fed, the cumulative weight of the Fed’s QE purchases in depressing longer-term yields, and the extremely low (in some cases negative) level of yields in other major markets (such as Japan and Europe) which has generated investor flows into the long-end of the US curve. That said, market participants and central bankers have pointed to reasons for “this time being different” at times in the past, yet recession has almost always followed.
US economic indicators are generally not supportive of the view that a US recession is coming, although growth is likely to slow over the course of this year. That said, the yield curve often provides an earlier warning signal than does economic data. Historically, the lags between 3m10y inversion and recession have ranged between around 6 months and 24 months. We still think the risk of recession is fairly low at this stage, especially given the Fed tightening cycle is now highly likely to be over, although a deep and sustained period of inversion (in both the 3m10y and 2s10s) would be more difficult to ignore.
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