The yield on the 10-year US government bond dropped from a high of 3.96% to a recent low of 3.13%. The key question for investors is: Will US long bond yields continue down or consolidate and move higher? In order to cast some light on this issue, I have analyzed a few key graphs and historical relationships, as reported below.
Sources: I-Net Bridge, Plexus Asset Management.
The first question to be answered is whether the sudden drop in the yield on the 10-year Note was a flight to security due to the current debt crisis in the European Union that began in Greece and subsequently spread to Portugal and Spain. The GDP-weighted spread between the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) has had an inverse relationship with the yield on the US 10-year Note since the liquidity crisis unfolded in 2008, with the US yield rising when the GDP-weighted PIIGS’ bond yield spread falls and vice versa.
Sources: I-Net Bridge, Plexus Asset Management.
The yield spread between PIIGS bonds and US bonds has a close relationship with the yield spread between emerging-market bonds and US Treasuries. It can therefore be argued that bonds in the PIIGS countries are essentially emerging-market bonds with similar risk attributes.
Sources: I-Net Bridge, Plexus Asset Management.
However, it is important to note that the emerging-market bond yield spread led the way at the advent of the liquidity crisis in 2008 while this time around the PIIGS’ yield spread and emerging-market bond yield spread moved together.
The yield spread between emerging-market bonds and US Treasuries, which is an indication of the risk of investing in emerging-markets, is a mirror image of the inverted Economist Metals Price Index. This relationship has the effect that investment risk of emerging markets increases when metal prices fall and vice versa.
Sources: I-Net Bridge, Plexus Asset Management.
Why the significant correction in metal prices? Metal prices ran significantly ahead of themselves, especially compared to the underlying global manufacturing sector as measured by the GDP-weighted (US, Japan, Eurozone, UK, China) manufacturing PMI.
Sources: I-Net Bridge, Plexus Asset Management.
It is even more evident where inventories at the London Metal Exchange rose from the third quarter last year while, contrary to normal behavior, metal prices rose as well. At this stage inventories of copper are falling at the same time as prices.
Sources: I-Net Bridge, Plexus Asset Management.
A significant gap also opened between metal prices and freight rates as measured by the Baltic Dry Index, with the gap now in the process of being closed.
Sources: I-Net Bridge, Plexus Asset Management.
It definitely smacks of significant speculative demand for metals on the way up and therefore the lowering of investment risk in emerging-market bonds and equities. The process is now being reversed. Is that the real reason behind the significant drop in yields in mature bond markets (calculated as the average yields of bond indices in the US, Japan and Germany) with investors shunning emerging-market bonds?
Well, the impact of that action is that bond market yields in mature economies have fallen way below the underlying fundamentals as measured by the Baltic Dry Index. Over the past few years the Index led bond yields in mature markets. Is it different this time around?
Sources: I-Net Bridge, Plexus Asset Management.
With the yield on the US 10-year government bond narrowly correlated with consumer confidence, is the bond market anticipating a drop in consumer confidence? At this stage it appears to be the case but it’s no train smash – yet.
Sources: I-Net Bridge, Plexus Asset Management.
The US bond market is anticipating a significant fall in the US GDP-weighted (manufacturing and non-manufacturing) index perhaps to below 50, and therefore a contraction in the US economy.
Sources: I-Net Bridge, Plexus Asset Management, ISM.
If the bond yield drops significantly more it means that due to the relationship between US banks’ lending policies and consumer confidence the bond market will expect banks to tighten their lending standards.
Sources: I-Net Bridge, Plexus Asset Management, Federal Reserve Board.
On its part the tightening of lending standards is therefore expected to lead to a lower ISM Non-manufacturing PMI.
Sources: I-Net; Plexus; Federal Reserve Board
A significant drop in consumer confidence is likely to lead to a decline in MZM velocity …
Sources: I-Net Bridge, Plexus Asset Management, Federal Reserve Board.
… and derail the US economy.
Sources: I-Net Bridge, Plexus Asset Management, Federal Reserve Board.
The answer probably lies in how the situation in the Eurozone pans out. Despite the crisis the preliminary Markit Eurozone Services PMI in May improved to 56.0 versus 55.6 in April, while the final Markit manufacturing PMI fell from 57.6 to 55.8 but was still expanding. While domestic demand in the Eurozone may be faltering, the manufacturing PMIs for export orders have risen as the euro weakness has started to boost exports of major countries in the Eurozone such as Germany. Employment in the manufacturing sector of the Eurozone has also risen for the first time in two years.
China’s manufacturing PMI for New Export Orders Index also held up well in May considering the debt crisis in the European Union and is backed up by a continued improvement in the Baltic Dry Index – an indication that global trade is improving. Shanghai containerised freight indices also continue to rise strongly, especially on the North American route, and are reminiscent of the Baltic Dry Index. The European route remains dull, though. The somewhat weaker China PMI as well as the weaker new export index can therefore be attributed to weaker European demand. However, the US is picking up a lot of the slack.
Sources: chineseshipping.com.cn, I-Net Bridge, Plexus Asset Management.
At this stage, with the markets in turmoil, it seems as if mature-market bonds are anticipating something considerably worse than current economic pointers suggest. They may be right or they may be wrong. What is clear to me, though, is that the downward correction of metal prices is not yet over and emerging-market risk is expected to increase further − but not for too long.
