US Yield Curve: Global Yellow Light?

The spread between the 10-year US Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators compiled monthly by the Conference Board. There is no trend in this series, which tends to cycle around zero. It is widely deemed to be one of the more accurate business-cycle indicators, predicting economic growth when it is positive and a recession when it is negative. The spread does tend to lead the y/y growth cycle in the Index of Coincident Economic Indicators.

Of course, the spread is also available on a daily basis. A more sensitive version of this leading indicator is the spread between the 10-year Treasury yield and the 2-year Treasury yield. That’s because the latter tends to anticipate moves in the federal funds rate, which is managed by the Fed. Currently, the spread is still positive but narrowing. It was 96bps on Friday, May 20, down from the most recent cyclical high of 266bps during December 31, 2013.

Interestingly, the spread has been narrowing as the Fed has been moving toward normalizing monetary policy. When QE was terminated at the end of October 2014, the spread was 185bps. It was down to 128bps on December 16, 2015, when the Fed hiked the federal funds rate by 25bps. It was down to 93bps following the release on Wednesday, May 18, of April’s FOMC minutes, which heightened expectations of a rate hike at the June 14-15 meeting of the FOMC.

The FOMC is tightening monetary policy because Fed officials believe that the US economy is showing more signs of sustainable growth with inflation rising back near their 2% target. Yet the yield curve is warning that the Fed’s moves could slow the US economy and halt the desired upturn in the inflation rate. Another possibility is that while the US economy might be strong enough to tolerate the normalization of US monetary policy, the global economy is much more vulnerable to Fed tightening moves.

It’s a small world after all, and it seems that national economies and financial markets have become more interdependent than ever as a result of globalization. Fed officials are still operating as though the US economy is relatively independent of the rest of the world. Until recent FOMC minutes, overseas economic and financial developments were almost never mentioned in the minutes. Nor was the foreign-exchange value of the dollar. The US economy may still be relatively independent, but that’s not to say that other national economies and their financial markets aren’t more dependent on the US and on Fed policy than ever before. Consider the following:

(1) World business-cycle indicators. The yield curve spread is often shown on a chart as a leading indicator for the y/y growth in US industrial production, which is one of the four components of the US Index of Coincident Economic Indicators. Given the size and importance of the US economy, it isn’t surprising to see that the US yield spread sometimes has been a good leading indicator of the growth rates of both global industrial production and the volume of world exports. It may be increasingly so now thanks to the ongoing globalization of national economies and financial markets.

(2) S&P 500 revenues & earnings. It also isn’t surprising to see that the growth rate of S&P 500 revenues per share is highly correlated with the growth rates of world industrial production and the volume of global exports. Roughly half of S&P 500 revenues comes from abroad. The global economic slowdown over the past couple of years certainly has weighed on US company revenues, which have weakened further due to the strong dollar since late 2014. In turn, the weakness in revenues and earnings has undoubtedly weighed on US companies’ spending in the US and overseas.

The yield curve spread on a weekly basis has been highly correlated with the y/y growth rates in both the forward revenues and forward earnings of the S&P 500. The recent narrowing of the spread isn’t a good omen for either of them.

(3) Central banks’ policy divergence. All of the above suggests that the US yield curve may be a good leading indicator not only for the US economy but also increasingly the world economy. The Fed’s monetary normalization has pushed up the 2-year Treasury yield from a 2014 low of 0.34% on October 15 to 0.91% on May 23. This reflects the relative strength of the US economy, particularly compared to the weakness in the Eurozone and Japan, which has forced both the ECB and BOJ to double down on their ultra-easy monetary policies, with more QE and negative interest rates.

The result has been that global fixed-income investors have been buying more US bonds because their yields exceed those available in the Eurozone and Japan. In other words, the short end of the yield curve may reflect the relative strength of the US economy and Fed tightening, while the longer end reflects weak global economic activity and easing by the other major central banks.

The divergence between the tightening of the Fed’s monetary policy and the ultra-easy policies of the ECB and BOJ has certainly contributed to the strength in the dollar and weakness in both the euro and yen since mid-2014. However, so far, the latter have failed to boost exports in the Eurozone and Japan, while the strong dollar has weighed on US exports.

Could it be that while the US economy can handle a gradual normalization of monetary policy in the US, the rest of the world cannot do so? That may be the message conveyed by the US yield curve.

(4) Kuroda’s kabuki. Japan’s economy certainly remains fragile. The BOJ adopted negative interest-rate policy (NIRP) at the end of January. The Japanese 10-year government bond yield was -0.10% on May 23. Yet the yen is 15% above last year’s low on June 5. On May 23, we learned that Japan’s flash M-PMI fell for the fifth consecutive month in May to 47.6, the lowest since December 2012. We also learned that Japan’s exports (in yen) fell 9.5% y/y during April to the lowest since January 2014. Imports plummeted 20.0% to the lowest since December 2010!

(5) Draghi’s drag. The ECB first introduced NIRP on June 5, 2014. The German 10-year government bond yield was only 0.18% on May 23. Yet the Eurozone’s industrial production rose just 0.2% over the 12 months through March. Just as frustrating for the ECB is that the CPI inflation rate remains just below zero. It was just -0.2% y/y during April, according to the flash estimate, while the core rate was 0.7%.

US Entitlements: In Government We Trust

In addition to earned income, another important source of purchasing power for consumers is government benefits. We can see this by subtracting US federal government spending on goods and services as reported in nominal GDP from total federal government spending as reported by the US Treasury. The difference is federal government spending on income redistribution through the various entitlement programs. Here are some observations:

(1) GDP vs. benefits spending. Federal government spending on goods and services as measured in the nominal GDP accounts has been essentially flat around $1.25 trillion (at an annualized rate) since 2010. Government spending on benefits to persons was relatively flat at a record high of about $2.25 trillion from 2009-2013. Over the past two years, it has risen 11.9% to a record $2.50 trillion.

(2) Benefits prevailing. Federal government spending on income redistribution has soared from just 10% of total federal spending right before President Johnson’s Great Society programs were passed (1964-1965) to 67% currently. This percentage includes so-called tax expenditures like the Earned Income Tax Credit (EITC), which is a refundable tax credit for low- to moderate-income working individuals and couples, particularly those with children.

The EITC is included in an outlays category called “Income Security” along with the Supplemental Nutrition Assistance Program, Supplemental Security Income, unemployment compensation, family support and foster care, and child nutrition.

(3) Impact on shopping. Of course, not all of the government benefits are paid in cash to beneficiaries. Medicaid and Medicare expenses are paid directly by the government to health care providers. However, this frees up income received by beneficiaries either from earnings or from cash benefits such as Social Security to spend on goods and services other than health care.

The sum of federal government outlays on income redistribution and labor compensation (wages, salaries, and supplements) rose to a record $12.4 trillion (at an annual rate) during Q1. That’s up 4.5% y/y.

The sum of the cash (or near-cash) benefits paid by Social Security and Income Security programs plus labor compensation rose to a record $11.3 trillion during Q1, up 4.1% y/y.

In other words, consumers have lots of purchasing power provided by earned income and by federal government income redistribution programs.

Zhengnengliang

In the eternal battle between the forces of light and the forces of darkness, I prefer the light side. I tend to be an optimist. However, in recent years, my optimism has been focused on the outlook for the US. I’m less enthusiastic about the Eurozone and Japan. In general, I’m not a big fan of emerging economies, particularly China. As a result, I have recommended a “Stay Home” investment strategy as opposed to the “Go Global” alternative.

On the dark side, I’ve written often about the credit excesses that have fueled excess capacity in China, which has to be the world’s biggest bubble ever. I was early in detecting the country’s capital outflows problem. I would like the Chinese authorities to know that no one else at Yardeni Research has contributed to my critical analyses of the country. But I will continue to write the truth, the whole truth, and nothing but the truth, though it is becoming increasingly dangerous to do so, especially for economists in China. The 5/3 WSJ included an article titled “China Presses Economists to Brighten Their Outlooks.” It ominously reported the following:

Chinese authorities are training their sights on a new set of targets: economists, analysts and business reporters with gloomy views on the country’s economy. Securities regulators, media censors and other government officials have issued verbal warnings to commentators whose public remarks on the economy are out of step with the government’s upbeat statements, according to government officials and commentators with knowledge of the matter.

The stepped-up censorship, many inside and outside the ruling Communist Party say, represents an effort by China’s leadership to quell growing concerns about the country’s economic prospects as it experiences a prolonged slowdown in growth. As more citizens try to take money out of the country, officials say, regulators and censors are trying to foster an environment of what party officials have dubbed "zhengnengliang," or "positive energy."

China’s President Xi Jinping seems to long for the glory days of Chairman Mao. He launched an anti-corruption campaign in 2012. It increasingly seems aimed at vanquishing his foes and at consolidating his power. His latest campaign aims to galvanize China around threats to national security. In recent weeks, the government has called for vigilance against spies. Even in the schools, children are playing games such as “Spot the Spy.” In mid-April, there was the first-ever National Security Education Day. Volunteers in Beijing handed out thousands of umbrellas imprinted with a hotline for reporting any perceived risks.

The accuracy and credibility of Chinese economic data have never been very good. Now they could get much worse. The official M-PMI may be sent to the countryside for a reeducation campaign. It edged down from 50.2 during March to 50.1 during April. It may have to be shot, or at least disappear, if it drops below 50.0 this month. Another candidate for summary execution is China’s monthly series on railways freight traffic. The series, which isn’t adjusted for seasonality, rebounded in March, offsetting most of February’s drop; but its 12-month average is down 17% from its record high on January 2014 and the lowest since November 2009.

By the way, FRB-Dallas Fed President Kaplan should probably watch his back too. In a recent speech, he warned:

[W]e are closely watching China, given its size and importance to world GDP growth … We estimate that [China’s GDP] growth rate will slow to 6.5 percent in 2016 and likely trend lower in subsequent years. China is dealing with high levels of overcapacity (particularly in state-owned enterprises), high levels of debt and an aging workforce. In addition, it has embarked on [what is] likely to be a very difficult [economic] transition.

I have instructed my colleagues that in the event of my disappearance, they should carry on without me and write only upbeat stories about China.