Australia - Canary in the Gold Mine

There was yet another rough night on Wall St and Euro markets last night and again a deepening inversion of the yield curve was central to that action (though not alone with more trade war fears and the worst unemployment print in Germany since the GFC).  As usual gold and silver held strong.

Last night saw plummeting US Treasuries (10 yr hitting 2.2%) and the UST 3m10Y spread dip to new cycle lows, and consolidating the inversion.  Indeed the market is now pricing in 3 rate cuts by the end of 2020.

At the shorter end of the spectrum the chart below shows how extreme the market is (the most since GFC).  The implications of that are that any new dovish stance by the Fed will likely not be dovish enough to outweigh market expectations.  That means the usual ‘cut rates > shares goes up’ scenario (i.e. the famous Fed Put) may not play out next time.

There is an argument that ‘this time is different’ because never before in history has the Fed thrown such stimulus at a market as it has since the GFC via QE and zero rates.  However Morgan Stanley undertook an exercise to adjust that 3m10yr yield curve above (as the yellow line) for the effects of QE and then QT (as the blue line).  As you can see below, QE took that curve to unprecedented highs in 2013 as the money printing machine was going flat out, and now to lows not seen since just before the GFC and Dot.com bubble AND inverting last November not the headline grabbing event in March this year.

But enough about the US because last night was extraordinary in that we also saw the Aussie yield curve invert as well!  Notwithstanding the RBA heavily hinting at a rate cut next round, the graph below now almost guarantees it.

Off that event there was a very interesting article on Bloomberg yesterday that refers to Australia (and NZ) as the proverbial ‘canaries in the mine’ for the global economy.  It’s very much worth a read, reproduced for you below:

“The Rich World’s Canaries Are Starting to Look Sickly

Ripples from Australia and New Zealand are often among the earliest signs of trouble for the northern hemisphere.

It’s always worth keeping an eye on events in the South Seas to see where the world economy is headed.

Thanks to their small, trade-dependent economies and open capital markets, ripples from Australia and New Zealand are often some of the earliest signs of trouble emerging in major northern hemisphere countries. In late 2008, the savage rate cuts by the country’s central banks in response to the developing global financial crisis were an early indicator of the rich world’s plummet toward a zero interest-rate policy. Now’s another time to watch what’s happening down under.

Race to the Bottom

New Zealand and Australia were the first to cut rates as the global economy weakened in the second half of 2008

New Zealand’s 10-year government bond rate dropped to a record low of 1.719% Wednesday morning, following heavy bond buying in the northern hemisphere overnight which further inverted a key piece of the U.S. yield curve. Just a few minutes later Australia’s 10-year yield slipped below the Reserve Bank of Australia’s cash rate target for the first time since 2015, a strong indicator that investors are counting on the rate cuts that RBA Governor Philip Lowe all but promised in a speech last week.

What a Downer

The yield on 10-year government debt down under has been plummeting

In some ways this shouldn’t surprise. New Zealand’s sovereign yields have been on a fairly consistent downward trend ever since those interest-rate cuts in late 2008. Australia’s have been slumping for six months, barely interrupted by a victory for the right-of-center Coalition in elections this month. Australian three-month overnight interest swaps – in effect, the market’s bet on the medium-term cash rate target – are sitting at 1.1695%, suggesting good odds that benchmark rates will be cut by 0.5 percentage point over the next 10 weeks.

At the same time, the speed of the latest leg down should be cause for concern. 

“What’s interesting about last night was that there was no particular catalyst” for the rally in bond markets, according to Su-Lin Ong, head of fixed income strategy at Royal Bank of Canada in Sydney. “That raises the question of whether markets are not yet positioned for this reassessment.”

Taking Stock

Australian and New Zealand stock indexes are only just off long-term highs

That certainly seems to be the case when you look at equity indexes. Those in Australia and New Zealand are just off record long-term highs, with robust valuations indicating investors are still betting on growth despite the darkening macroeconomic picture from the looming trade war and faltering Chinese economy. Should investors get cold feet and switch to bonds in greater numbers, expect to see those yields heading still lower.

China is a particular concern. Australia is the G-20 economy most exposed to Chinese exports; were New Zealand in that grouping, it would come third after South Korea, where government bond yields are also tracking toward their lowest level in almost three years.

As my colleague Daniel Moss has written, the image of Australia as a recession-proof economy badly needs to be marked to market, especially now that per-capita growth has been falling for two consecutive quarters. So far, the country has been spared the worst effects of the slowdown in China. Despite Chinese purchasing managers’ indexes that are struggling to stay in positive territory, short supplies of iron ore mean that prices for this key export have been strong, cushioning the economy thanks to its robust terms of trade.

Don’t count on that holding out indefinitely. Only demand-driven prices can be counted on for the long term. In both China and the world, that’s looking increasingly shaky. Australia and New Zealand may seem like small canaries in the context of an $80 trillion global economy. When they stop cheeping, though, it’s time to watch out.”