Curves flatten

Yield curves flatten, the Aussie dollar holds up and Aussie equities lag.

13 Nov 2017

Energy stocks extended their rally on the back of higher oil; tech stocks continued their march higher, dragging the S&P 500, Dow and Nasdaq to fresh records; and the Nikkei hit a 26-year high. If that wasn't enough, we are one year on from when Trump won the US presidency. Here's a wrap-up of the week.

Yield curves flatten

Global growth has picked up, the worldwide output gap is closing and a number of central banks have ended their easing bias – the US, Europe, UK, and Canada just to name a few. Yet the US yield curve is flattening. The 2/10 curve fell for nine consecutive days last week, its longest retreat in two years, and is plumbing a new 10-year low, a sign to some that an economic slowdown lurks on the horizon. With 2s10s at around 70 bps, the New York Feds recession model shows the probability of an economic contraction in the next 12 months is about 9%. This is low but it has increased quite a bit.

It should be noted, however, that a flatter yield curve is necessary but not sufficient to predict a recession. In the 1990s, for example, the 2s10s curve was flatter than it is now for more than five years straight - accompanied by rampant growth and a massive equity rally. It was only when the curve inverted in 2000 that the warning signs for recession started flashing red. So watch for an inversion of the curve, not just a flattening. The 10-year yield largely reflects expectations for the average interest rate in the next decade. When the long-term yield is lower than short-term rates, it suggests that the Fed will have to cut rates in coming years in response to a slowing economy.

This flattening is putting pressure on bank stocks – where profits are made from a steep yield curve. Banks borrow at short-term rates and lend at long-term yields. When the curve flattens, it curbs banks' ability to extend credit.

Aussie dollar

The Aussie dollar is holding up well when you consider the overwhelming consensus that the RBA's target rate will soon be below the Fed's benchmark. The RBA is likely to remain on hold until well into 2018. RBA Governor Philip Lowe said in a statement after the rate decision last Tuesday that "one continuing uncertainty is the outlook for household consumption. Household incomes are growing slowly and debt levels are high." Household debt is still growing faster than household income, putting upward pressure on the already high household debt-to-income ratio. The gap between debt and income growth has widened this year, despite macro-prudential policy moves.

In contrast, December will likely see the Fed raise rates another 25bpts, taking the official rate to 1.5%, in line with where the RBA cash rate sits. The last time this happened was in the year 2000 when the Fed was raising rates to combat the tech boom. The Fed raised rates from 4.75% to 6.5% in six steps. In response, the Aussie dollar dropped to a record low of less than 48 US cents. Interestingly, the Fed was raising rates at the end of 1999 and into 2000 at a time when core PCE inflation was tracking around 1.2%, below where it sits today at 1.3%.

Why are Aussie equities underperforming global peers?

The Australian equity market has been lagging its global peers for some time. Of the 42 equity markets that we monitor, Australia ranks 10th worst in terms of performance against its pre-GFC high (-13%). Greece is the worst with a return of -85% relative to its peak. Other markets include Italy (-46%), Spain (-32%), and Austria (-30%). What most of these markets have in common is their large sector weighting to financials. This can't be the only explanation, however, because there are other markets where financials is the largest index weighting and yet the market is above its pre-crisis peak –the UK (+12%) and Sweden (+31%) for example. Even in Canada, the economy most aligned to Australia, has an equity market that has surpassed its pre-crisis peak (+8.0%). Yet both equity indices are overweight financials and underweight tech (35% and 3.2% in Canada, 37% and 1.7% in Australia). Such market anomalies do tend to correct themselves in time.

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