Morning Commentary: Inversion Aversion

Foreign Exchange - Morning Commentary

Inversion Aversion

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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
U.S. markets have returned from the weekend to find global equities in a sea of red with equity markets in Europe and Asia negative.  U.S. markets opened lower but have since recovered. The most recent addition to the global growth wall of worry has been the inversion of the U.S. yield curve.  As we noted in our Week Ahead publication yesterday, the gap between 3 month and 10 year yields is now negative for the first time since before the Great Recession.   
Many in the markets see an inverted yield curve (short term yields higher than long term yields) as a worrying sign because every recession in the past 75 years has been preceded by an inverted yield curve.  However, it is important to note that every inversion has not proceeded a recession.  It is this dynamic that has divided people into two camps, one that believes an inverted curve signals a recession and one that believes this time is different. 
While we certainly are not completely discounting the signal sent by an inverted curve, there are many factors that suggest differences this time around.  Global QE, increased global demand for U.S. government bonds, and a shrinking term premium all indicate that there are structural changes to the overall market and implies that the interpretation of an inverted yield curve has changed. 
The marginal U.S. treasury buyer is now a foreign buyer, indicating that the U.S. yield curve is more a reflection of the global economy than the U.S. economy.  Furthermore, a reduction in the term premium, or the compensation an investor demands to hold a longer term bond, makes the yield curve more likely to invert.  To this end, research from the Fed shows that the yield curve, post 2012, is much more likely to invert than in the past.  Granted this analysis was done under a set of assumed conditions, so the magnitude of the result could be debated.  However the overall message remains clear.  With a smaller term premium than in the past, the frequency in which the yield curve inverts has increased even if the frequency of a recession has stayed the same. 
  • Brexit drama continues to move the markets.  This past weekend, a cabinet coup fizzled out as the two candidates for caretaker PM both declared their support for PM May.  As the PM has already survived a vote of no confidence, would have to voluntarily resign. 
  • Further votes on Brexit are expected this week.  Given that the order of voting matters, it is possible that the original order where MV3 voting is followed by indicative votes could be switched around.  As a final point, it has been reported that the government will not bring about a MV3 unless it is sure it has the votes to win.      
  • The euro found support this morning as German IFO data surprised to the upside, snapping a 6 month losing streak for the data series.   
  • Chicago Fed President Charles Evans spoke in Hong Kong and, in his prepared remarks, indicated that at the moment risks from the downside loom larger than those from the upside and opened up the possibility for easing should growth and inflation surprise to the downside.   
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