The Bond Market Has Gone Soft
(Bloomberg Opinion) -- The bond bulls have given up. At least it sure seemed that way Wednesday, as an almost six-week-long sell-off in U.S. Treasuries accelerated. The drop in bond prices pushed yields on benchmark 10-year notes to as high as 3.18 percent, above their previous peak for the year and the highest since 2011. The bottom line is that borrowing costs will increase for the government, companies and consumers.
On the surface, it’s not hard to see why traders are so spooked. The economy is in good shape, stocks are rallying to record highs and the consensus is that the next recession won’t hit before sometime in 2020. The big declines Monday came after the Institute for Supply Management said its index of U.S. service industries rose to a near-record level in September. As FTN Financial interest-rate strategist Jim Vogel put in in a note to clients, the report “does remove some of the doubts about the trajectory” of the economy in the third and fourth quarters. Even so, the weakness in the bond market feels a bit excessive. Perhaps, but the thing to know about the ISM index is that it’s based on a survey rather than actual results. Economists refer to surveys, which can be biased for a number of reasons that include political views, as “soft” data. The “hard” data, by contrast, is derived from such things as home sales, jobs created, retail spending and industrial production. An index put together by Bloomberg Economics indicates that the hard data has been falling consistently below forecasts since July. Another gauge created by the Federal Reserve Bank of New York that’s weighted heavily toward the hard data suggests that economic growth decelerated in the third quarter, to a 2.47 percent annualized rate from the heady 4.2 percent pace recorded in the April-through-June period.
This is more than just academic. One of the big head-scratchers this year been has been the sluggish pace of consumer spending despite surveys showing consumer confidence is at its highest since 2000. The government said last week that after taking into account inflation, consumer spending rose just 0.2 percent in August, the smallest increase since it fell in February. Can you really have a strengthening economy if consumers are cautious?
EARNINGS, LEVERAGE AND RATES — OH MY
The strong ISM services report on Wednesday also gave a tailwind to equities. The S&P 500 Index was on track to close at yet another record, bringing its year-to-date gain to almost 10 percent, before falling back a bit in late trading. The rally is all the more impressive when you recall that almost everyone agreed that surging bond yields would end the bull market in stocks. Clearly, equities reflect the view that the economy is strong enough to withstand higher borrowing costs. Perhaps that’s true for now, but what happens to corporate earnings when companies start to roll over all the super-cheap debt they’ve taken on since the financial crisis into higher-rate borrowings? Morgan Stanley puts the gross leverage in the investment-grade debt market at about 2.43 times, which is up from about 1.8 times a decade ago. For junk-rated companies, it’s just under 4.5 times, versus a little over 3.5 times in 2008. A more immediate problem for stock investors might be the coming earnings season, which will soon kick into high gear. Led by high-profile warnings from Netflix Inc. and Applied Materials Inc., the number of S&P 500 companies saying profits will trail analyst estimates outnumbered those saying they’ll beat them by a ratio of 8-to-1 in the third quarter, according to Bloomberg News’s Lu Wang. That’s the most since 2010, according to Bloomberg data.
CRISIS AVERTED, MAYBE
Italian government bonds rallied for the first time in five days Wednesday, tempering concern that a fiscal crisis would emerge and potentially throw the global financial system into turmoil. Although Italy set next year’s deficit target at 2.4 percent of economic output — higher than the 2 percent desired by the European Union — officials committed, in a partial concession, to reduce it in 2020 and 2021. “We are respecting the promises we made,” Prime Minister Giuseppe Conte said. “This is a serious budget, responsible and courageous. Our country needs strong growth.” The populist government’s deficit goal for next year is triple the previous administration’s target of 0.8 percent of gross domestic product set back in April, according to Bloomberg News’s Lorenzo Totaro. The government aims to reduce the shortfall to 2.1 percent in 2020 and 1.8 percent in 2021. “The re-profiling of the deficit path is a constructive response and suggests some reduction in tail risks,” Peter Chatwell, head of European rates strategy at Mizuho International Plc, told Bloomberg News. “For the sake of the Italian economy, we hope this signals that a lesson has been learned.”
The commodities market spotlight was on aluminum Wednesday. Prices jumped as much as 4 percent to $2,202 a ton, reaching a three-month high after the world’s largest refinery of alumina — a key raw material used in the production of aluminum — shut down. Norsk Hydro ASA said it will temporarily close the Alunorte alumina refinery in Brazil because the only area it can use for waste processing is already close to reaching its capacity. An alleged dam spill led to a series of legal troubles for the company, prompting authorities to order that it operate at 50 percent of capacity in late February, according to Bloomberg News’s Thomas Biesheuvel and Jack Farchy. A prosecutor said Friday it may take at least a year for the company to gain approval to return to normal production. The stoppage will increase the scarcity of alumina and raise the possibility of higher metal prices filtering through the global supply chain, which would affect manufacturers like automakers and canned drink suppliers. The market has been tight for months due to U.S. sanctions on Russia’s United Co. Rusal. The gains in aluminum helped send the Bloomberg Commodity Index up by 0.6 percent for its fifth straight gain.
FROM BAD TO WORSE
Emerging markets can’t catch a break. Not only is the MSCI Emerging Markets Index of equities down 11 percent for the year and a sister gauge of their currencies down almost 5 percent, but now it looks like developing economies are no longer getting a boost from higher oil markets like they had in the past. Although emerging-market economies include some of the world’s biggest exporters such as Russia, Saudi Arabia and Mexico, they also include big importers such as India and Turkey, according to Bloomberg News’s Paul Wallace. What’s different now is that the rise in oil prices is largely being driven by rising geopolitical conflicts, not broad-based global economic strength. The Institute of International Finance in Washington said Wednesday that it cut its projections for total non-resident capital flows to emerging markets in 2018 to $1.14 trillion, down more than $70 billion from its forecast in May and below the $1.26 trillion recorded in 2017. Overall, 17 of the 25 countries tracked by the IIF are projected to see a decline in non-resident capital inflows in 2018, according to Bloomberg News’s Colleen Goko.
There’s a big debate among economists these days about whether a good portion of the recent strength in the economy has been due to companies loading up on orders and stockpiling inventories in anticipation of a prolonged trade war. Although it’s too soon to definitively say that has been happening on a large scale, market participants will get another piece to the puzzle Thursday when the Commerce Department releases data on factory orders for August. The median estimate of economists surveyed by Bloomberg is for an increase of 2.1 percent, which would be the biggest gain since September 2017 and would reverse July’s 0.8 percent decrease. If it’s proven that companies have been stockpiling orders, then U.S. economic growth could be due for a sharp slowdown sooner rather than later.
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A Warning Sign on Italy’s Euro Membership: Francesco Garzarelli
Lira Develops an Immunity to Turkish Inflation: Marcus Ashworth
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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