European selloff highlights resumption of US treasury bear flattening

This morning, US stock futures are pointing to triple-digit losses after declines in Europe and in Asia. And the European indices are at a one-year low. There are quite a number of proximate causes for the weakness. But the overriding fear, as evidenced by the flattening of the US yield curve, is that the global economy is beginning to slow.

Secondary markers I look at include oil and gas prices. In a world of continued growth, sparking fears of overheating, we should see oil and gas prices continuing to rise. Instead, we are seeing these prices roll over. WTI is trading around $68 a barrel, down from a high at the beginning of the month over $76. Brent is a shade under $78, and also down over $8 a barrel in the same time frame. Gasoline and natural gas futures are also down in that time frame.

Here’s what I think is happening? Let’s start with China

There are two major concerns here. The first is China and the second is the US. China’s growth has begun to slow. And as growth has begun to slow, there is clear evidence that the Chinese government is moving away from liberalization measures in order to use state-owned enterprises as a conduit for stimulus.

This problematic because productivity in that sector is inferior. And it essentially means a favoring of the state sector over private enterprise, which, down the line, should see the Chinese economy’s growth stall further still, irrespective of any short-term gains. Moreover, the Chinese seem to be moving away from their cleansing of SOE balance sheets. And that’s going to add to fragility down the line, that will cause problems if the rest of the world slows in concert with China.

It’s not clear how much of the slowing is internally-generated and how much of the slowing is trade war-related. But the slowing in China will have a ripple effect across Asia because of supply chains. And so, the currency becomes a key unknown factor. The Renminbi is trading just above the 7 yuan to 1 US dollar level. And many people are looking at 7 yuan as a critical threshold.

In terms of the trade war with the US, it might be significant as well because US Treasury Secretary Steven Mnuchin has said he is willing to change the definition of manipulation used to designate a country a currency manipulator set out in a 2015 law. Mnuchin says he could use a 1988 trade act with a broader definition to label China a manipulator. If China is then deemed a currency manipulator, the trade war with the US would escalate significantly. And so, this makes the 7 yuan barrier even more critical.

The US has Fed and earnings jitters

In the US, the fears are a bit different. Yes, there is a concern about slowing. But it is mostly related to the Fed, which is now talking about overheating more than slowing. Fed Chairman Powell has said explicitly that he doesn’t fear the labor market overheating. Nevertheless, earlier in the month, Atlanta Fed President Raphael Bostic gave strong indications that the Fed could actually accelerate its 2019 rate hike timetable.

And we are already seeing the impact of the earlier rate hikes on the economy, with the housing sector as a canary in the coalmine. I noted near the end of yesterday’s daily that US existing home sales have fallen for six months on the trot now. And the National Association of Realtors – which is obviously pro-housing – says prices and supply of homes are rising, but buyer traffic is declining. This is particularly problematic in the West where for the second decade in a row we have sen the steepest price rises in the market. And NAR chief economist Lawrence Yun says “without a doubt there is a clear shift in the market.” We should expect further, and likely greater, weakness in the sector going forward – especially if the Fed accelerates its hike timetable.

At the same time, one of the proximate worries for equity markets is earnings. The S&P 500’s operating earnings was cyclically high in the last earnings season, Q2 2018. We saw $327 billion of operating earnings, which is almost double Q4 2015’s figure, during the mid-cycle slowdown induced by the shale bust. Now, just as with the shale bust, we could see earnings decelerate and then re-accelerate. But that is ultimately dependent on the broader economy.

Bear flattening is a bad sign

And here, the curve’s flattening is a worry. At 2.879%, two year rates are only down marginally from 52-week highs of 2.917%. Basically, they are steady. And they could rise if any of the five Fed officials speaking – Atlanta Fed President Raphael Bostic, Chicago Fed President Charles Evans, Dallas Fed President Rob Kaplan, Kansas City Fed President Esther George, and Minneapolis Fed President Neel Kashkari – says something hawkish. Bostic is the only voting member of the FOMC for 2018.

But 10-year rates are declining. They hit the 3.25% threshold, got all the way to 3.261%, and are now down to 3.149%. That’s a flattening of 8 basis points and takes away all of the potentially bullish steepening we had seen in September. We’re basically back to a position where we have to be concerned about curve inversion by year end. And that’s bearish.

So there’s a lot of pressure on the Fed here. And we can see the currency adding to that pressure, as the dollar has resumed its climb against all major currencies in the past month.

My take

The Fed is still very focused on the macro-economic signals it is getting. That means its looking at inflation, employment and growth. And all of those signals are positive. But, the Fed has to see the slowing in housing and think that it is a signal that its rate hike policy is starting to bite. So I would be surprised if we see the level of hawkishness now that we saw in the most recent period that has caused the dollar to rise and the curve to flatten again.

So I’m on the fence as to where this is headed. That’s because the macro numbers cannot be ignored. They support the Fed’s, at a minimum, sticking to its given forward guidance. The question now is about acceleration in 2019 and beyond. And we should be looking at their speeches to get a sense of what the Fed is likely to do going forward.

In the end, let’s remember that Fed policy acts with a lag. What we’re seeing now is the result of two years of hikes. And so, the policy coming online now won’t have a big impact until late next year. And I think we will begin to see much more credit distress by that time.