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A Bad Bond Auction Has Never Been So Welcome

A Bad Bond Auction Has Never Been So Welcome

(Bloomberg Opinion) -- History will show that the S&P 500 Index fell on Wednesday to its lowest level in 11 weeks, capping the benchmark’s biggest two-day decline since the start of January and putting it on track for a loss of about 5.53% for the month. But that would only be part of the story.

Here’s the other part: Stocks recouped about half their intraday loss after a lousy auction of $32 billion in seven-year notes by the U.S. Treasury Department. It was so lousy, in fact, that in the past 10 years, there was only one auction of seven-year notes that attracted lower demand than Wednesday’s sale, and that was back in early 2016. Normally, such poor results would roil markets, perhaps signaling that the bond vigilantes were making a comeback, finally pushing back against the government’s accumulation of $1 trillion debt and deficits. This time, though, it was perhaps more of a case that the recent bond market rally had gone too far, too fast, and that the lowest yields since 2017 probably overstate the weakness in the economy. In many ways, May’s slump in the stock market has much to do with the rally in Treasuries that sent yields so low. This week’s inversion in a key part of the yield curve, which in the past has been a reliable indicator of future recessions, only added to the jitters among stock investors who feel that bond traders keep a special economic crystal ball in their closets that allows them to see into the future. And while economists surveyed by Bloomberg expect growth to slow, they still see the economy expanding by a decent 2.6% rate this year. Also, it’s not like stocks are rich. At 16.7 times this year’s estimated earnings, the S&P 500 is trading in line with the average from 2014 through 2016, when earnings growth was nil, just like what is forecast for this quarter and next.

A Bad Bond Auction Has Never Been So Welcome

There’s also evidence that big investors have been jumping back into stocks. The State Street Global Markets monthly index of investor confidence for May rose the most since January 2018, climbing to 79.5 from 72.9 in April. (A level of 100 suggests investors are neither increasing nor decreasing their long-term allocations to risky assets.) Unlike survey-based gauges, this gauge is keyed off of actual trades and covers 15% of the world’s tradeable assets. “While the low level of the index points to risk-off behavior over the last few months, the solid uptick this month indicates some investors may be moving back in to buy the dip,” Kenneth Froot, a retired Harvard University finance professor who helped develop the index, said in a statement.

ABOUT THAT AUCTION
Not only did investors place bids for just 2.30 times the amount of seven-year notes offered by the government Wednesday, but the yield of 2.144% was about 2 basis points above where they were in the so-called when-issued market right before the auction. That’s a clear sign that investors felt the yields offered were too low. Bond traders have had a good run, with seven-year yields having tumbled from last year’s high of 3.20% in October. Even so, the market is pricing in almost two interest-rate cuts this year, which seems a bit aggressive, given unemployment is at an almost 50-year low. Then again, it’s hard to fight momentum, and the path of least resistance for yields is lower, according to Bloomberg Intelligence. Rates strategists Ira Jersey and Angelo Manolatos wrote in a research note Wednesday that a further deterioration in economic expectations would allow benchmark 10-year yields to test the 2.02% area, their low in 2017, versus 2.24% on Wednesday. ”Declining economic momentum appears to be the major driver behind the Treasury rally,” they wrote. “The slowing of industrial production and survey measures pointing to growth, though just barely, means yields remain at risk of moving lower.” Bond traders will get some key economic data in coming days, including the first revision to last quarter’s GDP report, personal income and spending for April and inflation.

A Bad Bond Auction Has Never Been So Welcome

THE MESSAGE FROM GOLD
It’s not just the bond market that’s signaling tougher economic times ahead – there’s gold, too. On its own, the price of the precious metal has fallen in recent months, suggesting no mass flight to haven assets, but the picture changes when you view gold compared relative to the price of silver. An ounce of gold bought more than 89 ounces of silver on Tuesday, the most since 1993, according to Bloomberg News’s Marvin G. Perez. When viewed this way, gold is certainly in demand relative to other precious metals. The ratio has swelled even as the dollar has appreciated. Many commodities are traded in dollars, so when the greenback strengthens, it makes commodities more expensive to purchase. As Perez points out, there are plenty of reasons for investors to be worried beyond the escalating trade war between the U.S. and China, a slowing U.S. economy and the inverted yield curve. Global economic growth is slowing, especially in key areas such as China, the euro zone and Brazil. Copper, which has a reputation for being a great leading indicator for the global economy given its wide use, has gotten crushed, heading for its worst month in more than three years. Also taking a dive is oil, with West Texas Intermediate crude dropping to $56.88 a barrel on Wednesday, its lowest since early March on a combination of rising supply and falling demand.

A Bad Bond Auction Has Never Been So Welcome

ITALY JOLTS THE EURO
The Bloomberg Euro Index capped its biggest three-day slide this month on Wednesday as investors become more worried about a potential debt crisis in Italy. While the global sovereign bond market has enjoyed a major rally, Italy is the only major market besides China in which yields are trading above their three-month average. Also, yields on Italian 10-year notes are 2.82 percentage points more than similar-maturity German bunds, expanding from 2.37 percentage point in March in a sign of escalating concern about Italy’s deteriorating fiscal situation. This is worrisome because Italy has $2.24 trillion of sovereign bonds outstanding, making it one of the world’s five biggest debtors. The European Commission confirmed on Wednesday that it will take the first step in a disciplinary process that would put Italy at risk of financial penalties, and demanded the government explain its failure to rein in debt before the European Union’s executive council makes its final decision next week. In a letter sent to the Italian Finance Minister Giovanni Tria on Wednesday, EC finance chiefs Valdis Dombrovskis and Pierre Moscovici said the country hasn’t “made sufficient progress towards compliance with the debt criterion” of the EU’s fiscal laws, Bloomberg News reported. The EC is considering proposing a disciplinary procedure for Italy, which could pave the way for a 3.5 billion-euro ($3.9 billion) penalty.

A Bad Bond Auction Has Never Been So Welcome

INAUSPICIOUS START
Saudi Arabia’s first day was as an officially recognized emerging market was a flop. The benchmark Tadawul All Share Index fell 1.60% on Wednesday even as the broader MSCI Emerging Markets Index was largely little changed, dropping just 0.25%. The declines also came even as Wednesday was the first day that MSCI Inc., the biggest stock index compiler globally, added an initial batch of Saudi shares to its benchmark tracking equities from developing economies. The poor debut may indicate that the kingdom will have challenges to keep investors’ excitement flowing after a big run-up in Saudi shares during the first four months of the year, according to Bloomberg News’s Abeer Abu Omar and Filipe Pacheco. The Saudi index is down 9.57% in May, poised for its worst monthly performance since January 2016. That’s even though JPMorgan Chase & Co. estimates the inclusion of Saudi equities into the MSCI EM Index may lead to $15 billion of flows into the kingdom’s stock market. Perhaps many global investors view Saudi Arabia as somewhat of a pariah for its role in the killing of Washington Post columnist Jamal Khashoggi. It also probably doesn’t help that Saudi Aramco’s debut bond offering in April didn’t go so well, with risk premiums on the securities rising since the offering.

A Bad Bond Auction Has Never Been So Welcome

TEA LEAVES
Traders may not want to leave the office for lunch Thursday, as Federal Reserve Vice Chairman Richard Clarida will be addressing the Economic Club of New York at noon. As one of the most influential members of the central bank after Chair Jerome Powell, Clarida will either have a chance to push back on the rally in the bond market, where traders are pricing in one to two interest-rate cuts this year, or give his stamp of approval. Either way, his comments have the potential to be market-moving. Clarida, who ranks as “neutral” on the Bloomberg Economics Fed Spectrometer, has recently noted that the neutral level of interest rates has fallen in the U.S. and globally due to several factors, including aging populations, changes in risk-taking behavior and a slowdown in technology growth.

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.

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