Downside Not Upside Global Risk

By Jeffrey Snider

The UST yield curve continues to flatten (as it does elsewhere). All sorts of mainstream articles have been published lately about it. Many of them often refer to academic pieces ostensibly trying assuage all fears about the yield curve’s threatening inversion. Fret not the distortion, they say.

And they are right. As I constantly remind people, it’s not inversion that anyone should worry about. All that matters is where the curve has been flattening, and not just recently. For years, it’s been shriveling and shrinking, a poignant likeness for the global economy.

Not so in the mainstream. The economy is booming. To reconcile how the yield curve could behave this way while strong growth is happening all sorts of intellectual byproducts are employed. Here’s another one published today:

Goldman Sachs Group Inc. is telling traders to be wary of reading Federal Reserve Chairman Jerome Powell’s comments last week as dovish for the path of interest rates.

Ten-year Treasury yields fell Friday on Powell’s speech at the Kansas City Fed’s annual policy symposium, when he said “there does not seem to be an elevated risk of overheating.” What’s more, the maturity’s spread over two-year yields is close to the lowest since 2007.

Apologies to Goldman Sachs, that’s not what’s holding rates lower. Long end investors don’t care if Chairman Powell is dovish, hawkish, or whatever position might sit in between. They are betting he’s wrong about whichever position he may take at various times. There is no “strong” economy, a reality that the flat 3% UST curve says will be revealed soon enough.

It starts with decoupling; or, rather, how decoupling isn’t a thing. The word has been used over and over, several times switching positions. In early 2008, the global economy especially EM’s were to decouple from weakness in the US and Europe. It didn’t end up that way, of course, as the Great “Recession” by 2009 hit everyone via the eurodollar system.

Now, as in 2015, decoupling is meant to be US strength in the face of “overseas turmoil.” The 5% US unemployment rate didn’t mean much three years ago, so perhaps a 4% one will this time around – though that’s not very likely with nothing corroborating the number.

Instead, we need only look around and marvel at the mirage bond and funding markets have already sniffed out. Take Brazil, for example. The real is today settled close to the worst level of the prior “rising dollar.” Despite repeated and emphasized assurances just two months ago that central bankers there could manage and defend their currency, they have but tried.

That’s just Brazil, everyone says. The latest polls show leftists in a commanding lead in the upcoming elections, purportedly scaring investors away. That’s not what makes eurodollar lenders upset and uncertain; it’s why the surveys keep showing this sort of major political upheaval. If things are going so well, why aren’t they going so well?

For every Brazil being Brazil there is another example where it isn’t so tidy to dismiss. The most prominent illustration of the more uniform nature of global shifts this year is unfortunately brought to us by India. The Indian rupee is actually setting a new record low today. India is not in any way, shape, or form Brazil.

It doesn’t matter, nor does it count that in relative terms the Indian economy is in pretty good shape. The eurodollar world doesn’t attribute rupees to Jay Powell but to global economic forces way beyond his limited monetary comprehension. The rupee drops along with the real because the global downside is re-emerging in some places very clearly.

When talking about the global economy it often makes sense to start with the Chinese piece of the BRIC’s rather than Brazil or India. The marginal economy is directed by Chinese conditions, themselves a reflection of the true state of the US and Europe. By China’s reckoning, there is no boom going on anywhere. That’s why INR and BRL fight the same trouble since April.

The latest statistics from China aren’t encouraging. For all the talk about rebalancing that economy away from industry, there just is no getting away from its manufacturing/export base. In that basis, industrial profits rose by just 16.2% year-over-year. As with a lot of Chinese numbers and comparisons, this sounds like a fantastic result but it is very far from one.

Not only is 16% rather low, it is artificially inflated – by a whole lot. Nearly two-thirds of profit growth this year and last are nothing more than prices, with steel mills and oil companies rolling out practically the same low volumes as the 2015-16 downturn but now at somewhat higher prices.

Even more important, private industry has never recovered from the last “rising dollar.” The difference here is immense, a very clear “L”:

The private industrial base was China’s economy, at least up until the 2012 global (eurodollar-driven) slowdown. From January to July 2018, private industrial profits grew by 10.3% over the same months in 2017. That’s about one-fifth the levels of what once drove the Chinese economy to its miracle, as well as expectations after the Great “Recession” things would actually and fully recover from it.

In early 2017, at what looks more and more like the apex of Reflation #3, private industry merely repeated 2013-14 and now it’s already back to levels more like 2015.

It’s worse on the top line. Again, private industrial growth used to be what set Chinese growth. It still is, only instead of leading China’s economy back into actual growth it is at the front edge of this new age where there isn’t any. Private industrial revenues are now dragging the whole thing down.

From this perspective, you can therefore appreciate why eurodollar suppliers and redistributors might be more than a little apprehensive about this whole globally synchronized growth narrative. It does appear to be synchronized, alright, just as a huge worldwide “L.”

China’s industrial output is a comprehensive reflection of worldwide economic circumstances as they are. There’s nothing more than illusions to the economic side of Reflation #3, and the more time passes the more likely it becomes nothing else will ever show up. Thus, downside risks are once again paramount.

That’s why the yield curve is stuck around 3% nominal. Hawkish or dovish doesn’t matter in the slightest. Jay Powell talks a good game, but he has no idea what he is talking about. This shouldn’t be surprising. The FOMC can’t even get federal funds right and that’s the only thing they actually do.

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