July Rates Update

Monthly Commentary

August 14, 2018

After spending nearly all of June stuck in neutral, 10y Treasury yields managed to push 10bps higher to close July at 2.96%, supported by stronger U.S. growth. Despite this sell off in 10y Treasury yields, the yield curve was still flatter overall on the month with the spread between 2y and 10y Treasuries falling 5bps to 28bps. Similarly, U.S. equities continued to grind higher alongside the U.S. dollar, with the latter continuing to exert downward pressure on the EM risk complex.

Chinese Credit Growth

* Adjusted for local government (LG) bond issuance.
Source: Haver analytics, Goldman Sachs Global Investment research

As U.S. risk assets ground higher in July, their Chinese counterparts continued to struggle to find traction amid a sharp slowdown in credit growth and burgeoning U.S. – China trade tensions. While the S&P 500 pushed almost 4% higher in July the Shanghai Composite fell 6% and is now 18% lower for 2018. Interestingly, this has not come amid a growth shock in China as real GDP growth of 6.8% YoY in H1 was comfortably above the state target of 6.5%. Additionally, state GDP is highly scrutinized by the Chinese authorities so above-target growth may not necessary tell the whole story. It may be that recent efforts to slow down credit growth were too successful and are starting to manifest in the real and financial economy. A recent study by Goldman Sachs estimated credit growth in China has decelerated to 11.2% YoY, the biggest drop recorded. In order to combat this slowdown, the PBoC has eased monetary policy both by reducing the 7-day repo rate and by cutting reserve requirements. The authorities have also eased fiscal policy via a loosening of budget constraints for local governments.

Likely the most important piece of the China economic puzzle for market participants, the CNY has been allowed to depreciate 8% on a trade weighted basis since June. This 8% drop has largely offset the 10% tariffs planned by the U.S. administration, potentially prompting the U.S. government’s recent announcement that it would consider raising tariffs to 25% on $200 billion worth of Chinese exports. If Chinese authorities stand firm and allow for another 15% devaluation against the USD to adjust for the additional tariffs we would likely start to see U.S. inflation readings fall along with commodity prices as rapid U.S. dollar appreciation feeds through into the U.S. economy. Further impacts of CNY devaluation will potentially be seen in other Asian exporter countries like Korea and Japan that will be forced to adjust to a more competitive CNY. This kind of exogenous shock to price levels has given the FOMC cause for pause under past leadership, but it remains to be seen how Chairman Powell will handle any unwanted USD strength.

U.S. real GDP grew 4.1%, annualized, in Q2, its best performance since 2014. As expected, trade contributed noticeably, boosting the headline GDP growth rate by 1.1 percentage points. Exports jumped more than 9% ahead of the implementation of tariffs in early July. Overall, growth was healthy, led by strong consumer outlays of +4.0% annualized, solid business spending, including expenditures on equipment, and a third strong gain in government purchases. The most notable area of weakness was housing, which posted a second small quarterly decline in Q2. On balance, there was nothing in the report that suggests the FOMC will be forced to forgo a rate hike at the September meeting.

While U.S. growth continues on stable footing, the Bank of Japan made some adjustments to its own pro-growth policies at the July policy meeting. Though there were no changes to the policy rate, the BoJ introduced forward guidance under which it will maintain current ultra-low interest rate levels until the effects of the consumption tax hike planned for October 2019 have passed. With regard to long-term bond purchase operations, the BOJ said it would take a flexible approach, and at the post-meeting press conference Governor Haruhiko Kuroda indicated that the bank would tolerate a wider level of fluctuation in the 10-year JGB yield, of around 20bp from its 0% target, versus around 10bp at present. This change in BoJ policy could have major implications for global yield levels as a major force that has held 10y JGB yields near 10bps has now abated. Now that the Japanese long end is free to explore slightly higher yields we could see U.S., UK, and German yields venture higher in sympathy as a key source of demand for duration moves toward the background.

July also saw policy action from the Bank of England in the form of a 25bp rate hike that lifted the policy rate to 0.75%. The rate hike was accompanied by modest upward revisions to growth and inflation forecasts for 2018 and 2019 as fiscal headwinds are expected to slowly recede. The BoE made it clear that this was not the start of any true hiking cycle, just another one-off adjustment to the policy rate. If the economy continues on the path set up by BoE forecasts, it appears the next hike is likely at least 6-12 months away. Furthermore, until the full plan and impact of Brexit is known, it will be difficult for the BoE to provide reliable forecasts.

With only August standing between markets and the fourth quarter of the financial year, the period of relative calm that accompanies summer months is almost unanimously expected to subside and give way to significantly more volatile market conditions. Potential flare points range from U.S.-China trade conflicts to ECB tightening attempts to errant tweets but cross-asset volatility remains unimpressed as both equity and Treasury volatility remain stuck to the floor. With plenty of catalysts on the calendar for the fourth quarter there should be sufficient opportunities for asset volatility to rise little by little or all at once.

U.S. Treasury Market Overview

Source: Barclays Bloomberg

 

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