Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Week of Sep 09, 2019

Negative yields: A new and unusual characteristic of the bond market

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There are currently US$17 trillion worth of bonds in the world that are trading with a negative yield.¹ This includes US$16 trillion in government bonds as well as roughly US$1 trillion in corporate bonds. The majority of the negative yielding debt was issued by three countries: Germany, France, and Japan. This unprecedented situation raises a number of questions.

One of them I often hear is this: How is it possible for negative yields to exist? Why would any investor purchase a bond that offers a negative yield? The answer is that many large institutions need to keep some part of their portfolios in safe assets where there is no risk of capital loss. Given that they cannot simply stuff cash in a mattress, they are willing to accept a negative yield on bonds for which there is no risk of capital loss or default.

Yields on bonds are negative for several reasons. These include low and declining expectations of inflation, low expectations of economic growth, strong demand for safe assets at a time when business investment is weak, and expectations that the European Central Bank (ECB) will resume purchases of government bonds. Some observers see the negative yields as evidence of a bubble in the bond market. Others, however, believe that stark demographics have contributed to a long-term trend of very low inflation, thus ensuring that bond yields will remain low or negative for some time to come.

Yields on US government bonds remain positive, in part a reflection of faster economic growth and higher inflation than in Europe and Japan. The reality, however, is that although US yields are positive, they are actually negative when adjusted for inflation. The yield on the 10-year bond is currently 1.44 percent while the so-called breakeven rate is 1.55 percent.² The breakeven rate is what investors expect of annual inflation over the next 10 years. Thus the real yield on the bond is roughly -0.1 percent. In other words, investors expect that, after inflation, they will lose some of their capital when purchasing US government bonds. It is not the first time this has happened. A long-term bond yield is, theoretically, a prediction about the future of short-term rates. Thus a negative real yield means that investors expect future short-term rates to be lower than the rate of inflation. This implies that they expect the Federal Reserve to cut rates in the future in order to offset weak or negative economic growth.

Is it possible that nominal US yields will fall into negative territory? Yes. If investors were to become more pessimistic about US growth and inflation, and if the Federal Reserve reverts to asset purchases as part of an effort to ease monetary policy during a future recession, then yields could fall quite quickly. Moreover, trade uncertainty has boosted the attractiveness of safe assets. US Treasuries are seen as especially safe (along with German and Japanese government bonds). If the trade war worsens, one can imagine a scenario in which money flows more rapidly into US Treasuries, suppressing yields and boosting the value of the US dollar. Actually, this is already happening with US bond yields falling and the US dollar rising.

The nature of the next recession

Until about 30 years ago, most recessions in industrial countries came about due to economic overheating and the commensurate tightening of monetary policy. A decline in demand led to a surge in inventories and the need to cut back production, contributing to a recession. In recent decades, however, this has not been the case. Rather, recessions have mostly come about due to financial imbalances. Plus, they’ve come about less frequently than in the past. This reflects the shift away from a goods-based economy toward a less volatile services-based economy, implementation of information technology thereby enabling better inventory management, and better central bank management of inflation expectations. What will cause the next recession? Financial imbalances remain a possibility, especially as the world has loaded up on corporate debt. But the next recession might come about due to a collapse of investment in light of trade wars and trade uncertainty.

It is worthwhile to recall the Smoot–Hawley tariff in the midst of the Great Depression. While economists mostly agree that the Smoot–Hawley tariff did not cause the Depression, they also agree that it exacerbated the downturn significantly. The tariff, which was legislated by the US Congress in 1930, caused import prices to rise by more than 40 percent. It was followed by retaliatory action by other countries. It led to a 66 percent decline in global trade.³ It reduced real consumer purchasing power, stifled business investment, and contributed to a very sharp decline in asset prices. While the tariff actions recently taken by the United States and China are not as dramatic, they are the most significant protectionist actions since the Great Depression and are already having a negative impact on global economic activity.

When the next recession comes, will central banks be able to act? Yes, but with interest rates already low, central banks are constrained to a degree never before seen. Would lower interest rates do anything when they are already historically low or negative? Possibly not, especially in countries where rates are close to or below zero. And would quantitative easing (asset purchases) make any difference if business investment is held back by trade uncertainty? We don’t know. However, it is likely that quantitative easing would not be as impactful as in the last recession, especially given that financial market stress is not likely to play as large a role in the next recession as it did in the last one. Finally, would governments engage in fiscal stimulus? That is a political question and is already a source of debate in Germany. Still, in an environment of historically low interest rates and stifled business investment, fiscal policy could be the best solution to a downturn absent a reversal of the trade war. Notably, fiscal stimulus in China is already having some positive impact there.⁴

The US job market decelerates

The US government released its latest employment reports last week. There are two reports: one based on a survey of establishments and the other based on a survey of households. The establishment survey findings⁵ revealed that 130,000 new jobs were created in August, the lowest in three months and relatively low compared to growth over the past year. Monthly job growth has averaged 158,000 in 2019, down from 223,000 in 2018. Thus it appears that the job market is decelerating. That said, it should be noted that job growth continues to exceed the level needed to absorb new entrants into the labor market. Thus it remains a healthy and very tight job market. Employment in the mining industry, which includes oil and gas production, fell for the third consecutive month as relatively low energy prices took a toll on employment in the industry. The manufacturing sector produced only 3,000 new jobs after producing only 4,000 in the previous month. We already know that manufacturing output is declining, so the weakness in employment is no surprise. There were only three industry categories that saw strong job growth. These were professional and business services (such as Deloitte), which was up 37,000; health care, which was up 36,800; and government, which was up 34,000. The third category was boosted by temporary hiring in anticipation of conducting the decennial 2020 census. Excluding the surge in government employment, job growth was fairly modest.

In addition, survey results reveal that average hourly earnings were up 3.2 percent from a year earlier, lower than the growth rate seen earlier in the year. Thus despite the tightness in the job market, we are not seeing an acceleration in wages. This is a surprise and a puzzle for economists. It demonstrates that, contrary to past experience, the tightness in the job market is not creating inflationary pressures. There is a debate among Federal Reserve leaders as to whether the weakness in wages will be sustained or is only a temporary phenomenon. If temporary, then higher inflation remains a risk and the Fed should be cautious about easing monetary policy. If, however, the weakness of wages is here to stay, then the Fed can more confidently ease monetary policy.

The findings of a separate survey of households⁶ indicate that the unemployment rate remained steady at 3.7 percent in August. The number of people participating in the labor force grew much faster than the growth of the working age population. The result was that the participation rate increased to match a level last seen in February and the second-highest level since 2013. The participation rate had steadily fallen since the start of this century but stabilized around 2014.

The latest on the trade front

Last week, the United States imposed a 15 percent tariff on US$112 billion in imports from China.⁷ Some more tariffs are set for October and December. The tariffs imposed last week target apparel and other consumer goods, auguring an increase in consumer prices in the months ahead. Chinese retaliatory tariffs also went into effect, specifically targeting soybeans and other farm products. In addition, China submitted a complaint to the World Trade Organization (WTO),⁸ saying that “the tariffs imposed by the United States severely violated the consensus reached by the two heads of state in Osaka.” This was in reference to the agreement between Presidents Trump and Xi to postpone further tariff action while negotiations take place. China’s Commerce Ministry added that “China will firmly safeguard its own legitimate rights and interests and resolutely uphold the multilateral trading system as well as the international trade order.” The WTO action means that China intends to adjudicate the dispute, thereby reducing the likelihood that an agreement will be reached through bilateral negotiations.

The two sides were set to hold high-level meetings this month. However, China has indicated that the United States must halt new tariffs in order for talks to proceed. In response to the WTO action, equity prices and bond yields fell as investors became more pessimistic about a resolution of the trade dispute. The yield on the US government’s 10-year bond fell to 1.44 percent, the lowest level since July 2016.⁹ This meant that the inversion of the US yield curve became more intense. The value of the Chinese renminbi fell to the lowest level in more than 10 years, approaching 7.2 renminbi to the dollar. Interestingly, there is evidence that the Chinese economy, having been buffeted by the trade dispute, is rebounding modestly, with manufacturing activity increasing in August according to the latest purchasing manager’s index.¹⁰ This is likely the result of government stimulus. It could mean that China’s government feels sufficiently confident about growth, and pessimistic about the prospect for an agreement with the United States, that it will not make any further concessions on trade.

China eases credit conditions

In the midst of relatively slow growth and the threat of further troubles from the trade war with the United States, China’s policymakers last week took further steps aimed at stimulating domestic demand. Specifically, the central bank cut the required reserve ratio (RRR) for banks,¹¹ thus enabling them to boost the volume of lending. This was the third time this year that the RRR has been cut. The latest cut will enable banks to boost lending by about US$126 billion. In doing this, China’s central bank is acting consistently with many other central banks around the world that have been easing monetary policy. It is now widely expected that China’s central bank will also cut interest rates.¹² One potential impact will be to stimulate further depreciation of the Chinese renminbi. Lately, the central bank has allowed the renminbi to decline in value. This helps to offset the impact of US tariffs on Chinese exports to the United States. It also boosts the competitiveness of Chinese exports to other countries. And, it irritates the United States, which recently labeled China a currency manipulator. Still, China’s leaders appear unfazed by US concerns.

It seems likely that policymakers will continue to ease monetary policy in order to boost domestic demand at a time of stress on China’s export sector. This is especially true in light of reports that a trade deal is highly unlikely any time soon. However, it should be noted that monetary policy tends to act with a lag. Therefore, it may take some time before results are seen. Meanwhile, China’s economy could decelerate further as the impact of new tariffs kicks in.

Week of Sep 02, 2019

Uncertainty is the principal factor creating the risk of recession

When I was in graduate school more than 30 years ago, there was a class offered entitled “The economics of uncertainty.” It examined the economic impact when participants in the economy lack all the information needed to make decisions. It mostly focused on microeconomics, analyzing how buyers and sellers in a given market act when there is a paucity of information. It examined the impact on output, demand, pricing, and investment. As a student focused on macroeconomics, I found the class to be interesting but not especially relevant to the topics that interested me. Boy was I wrong!

Today, uncertainty is arguably the dominant factor driving the global economy and the principal factor creating the risk of recession. Imagine you are a US-based technology company that produces goods in China. If you know with metaphysical certainty that the United States will impose a 25 percent tariff on all Chinese imports next week, that those tariffs will remain in place for a decade, and that the United States will not impose similar tariffs on other countries, you might not be happy, but you can make an informed decision. You might decide to invest heavily in shifting production from China to Vietnam or you might invest heavily in technologies meant to reduce your costs. You could even decide to do nothing, hoping that US consumers will not be especially price sensitive. The point is that with a degree of certainty, you can decide on an action.

However, if you don’t know if tariffs will go up or down, if you don’t know whether other countries will be targeted, and if you don’t know what other changes in trading rules might be implemented, then it is difficult to decide what to do. This, by the way, describes the current environment, and it that has already caused countless companies to put major investments on hold.¹³ That, in turn, has meant a slowdown in overall business investment in the United States, Europe, and China, and disrupted supply chains that were designed to take advantage of a world of liberal trade. And, finally, this uncertainty has contributed to the slowdown in economic growth around the world. It can be argued that the uncertainty about tariffs has done more damage than the tariffs themselves. However, the tariffs have only recently risen to a level that will be onerous to consumers and businesses. Thus, the direct impact of tariffs is likely to be much greater in the months ahead than was true in the past year.

Lately, uncertainty has become greater. In a recent week, China boosted tariffs on the United States, the United States responded by threatening to boost tariffs on China, the US president “ordered” US companies to get out of China, the US president said he had second thoughts, his advisors said he didn’t, and then the president said that China was coming back to the table and a deal might be in the works.¹⁴ All of this happened in a matter of days! Amid this, investor sentiment has gone back and forth, with asset price volatility being relatively high.

Many business leaders have started to express frustration. They are extremely averse to uncertainty and would most likely prefer the certainty of onerous tariffs to uncertainty about everything. Josh Bolten, who leads the Business Roundtable and was Chief of Staff to President Bush, said, “The risk is that everybody’s going to slam on the brake, and that would be a disaster.”¹⁵ He said that the latest mix of policies could “disrupt trade and commerce in a way that would cause huge damage—not just to the Chinese economy, but to the global economy and the US economy.” Jay Timmons, who leads the National Association of Manufacturers in the US, said, “America’s manufacturing workers will bear the brunt of these retaliatory tariffs, which will make it even harder to sell the products they make to customers in China.” And David French of the National Retail Federation noted, “It’s impossible for businesses to plan for the future in this type of environment. The administration’s approach clearly isn’t working, and the answer isn’t more taxes on American businesses and consumers. Where does this end?”

Finally, uncertainty extends beyond the realm of trade. The uncertainty about how trading relations will evolve has created uncertainty about how central banks will react. Recently, Federal Reserve Chairman Jay Powell expressed concern about this issue. He said that the Fed must “focus on things that seem likely to affect the outlook over time or that pose a material risk of doing so. But fitting trade policy uncertainty into this framework is a new challenge.”¹⁶ In other words, setting monetary policy in the midst of trade uncertainty represents new territory for the Fed and, consequently, means uncertainty for investors who follow the Fed’s actions. Powell added, “Trade policy uncertainty seems to be playing a role in the global slowdown and in weak manufacturing and capital spending in the United States.” Finally, Powell offered thoughts about how the trade situation is likely to influence policy decisions, saying, “While monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade. We can, however, try to look through what may be passing events, focus on how trade developments are affecting the outlook, and adjust policy to promote our objectives.”

Two European countries at a crossroads: Italy and Germany

Yields on Italian government bonds have fallen to a record low, with the yield on the 10-year bond falling below 1.0 percent for the first time ever.¹⁷ This follows the recent collapse of the Italian government and the announcement that a new government is in the works. Many investors evidently believe that the next government will be more market-friendly than the last one. The government that collapsed involved a coalition between the far-right League and the far-left Five Star Movement. These two parties have little in common but had agreed on a fiscal policy that threatened to violate European Union (EU) rules. The League withdrew from the government, leading to the resignation of centrist Prime Minister Conte. Now, an agreement has been reached under which the centrist Democratic Party will join the Five Star Movement. Interestingly, it was decided that Conte will return to lead the new government until elections can take place, possibly next year.¹⁸ Thus investors see a possibility of a modest period of stability. Hence the decline in bond yields. Still, Italy’s situation remains murky. The economy is not growing; in fact, it has barely grown for quite some time. Inflation is very low, unemployment is high, government debt is very high, and politics are fragmented and dysfunctional. The most popular politician in the country, Matteo Salvini, who leads the League, was excluded from the new government and continues to call for elections that he might very well win. And yet bond investors appear confident. They evidently expect that the European Central Bank (ECB) will soon resume purchases of government bonds. Moreover, they expect that the ECB will retain its policy of “doing whatever it takes” to prevent the collapse of the eurozone. This likely means acting as lender of last resort to troubled governments. In addition, a centrist caretaker government is not likely to engage in a budgetary conflict with the EU as did the recent government. Thus, there is a chance for greater fiscal probity. Still, Italian bond yields remain higher than other European governments’ bond yields. Ten-year bonds in Germany, France, the Netherlands, Finland, Austria, Ireland, and Belgium currently offer a negative yield.¹⁹

In Germany, where the economy is on the edge of recession, the government continues to run a budget surplus for the fifth consecutive year. This is by design. For the past decade, the German constitution has mandated that the structural deficit remain below 0.35 percent of GDP,²⁰ and there is broad bi-partisan support for maintaining surpluses. Yet standard economic theory suggests that, although budgets ought to be balanced over the course of the business cycle, it is sensible for deficits to rise during downturns. That is because when the private sector cuts back on spending, it is helpful if the government borrows unused funds and spends them, thereby moderating the business cycle. In fact, if one observes a graph of changes in economic output over the past century, it became far less volatile after World War II when the use of fiscal policy to offset the business cycle was widely implemented. At the same time, the argument against fiscal stimulus is that borrowing by governments in competition with the private sector drives up borrowing costs, thereby stifling private sector investment. In the case of Germany, however, borrowing costs are currently negative. Thus, if the government were to borrow and boost spending on infrastructure, it could wind up having a net positive impact on economic activity and not cost the government anything in the long run. Currently, there is increasing discussion about doing just that. The International Monetary Fund (IMF), many private sector economists, leaders of German business organizations, and foreign leaders have called on Germany to engage in fiscal stimulus in order to fight recession.²¹ French President Macron criticized what he called Germany’s “perpetual fetish” with balanced budgets. German leaders, nonetheless, defend the policy, saying that the budget restrictions have served Germany well. Its economy has grown steadily for nine years and the government has only a modest amount of debt—a fact that will serve it well as the population ages and the ratio of workers to retirees declines. Having fiscal probity will make it easier to fund the needs of an aging population. Finally, Germany’s role in the eurozone plays a role in this debate. With unemployment high in Italy and Spain, an increase in German spending would not only boost German demand, it would boost demand in Southern Europe as well, thereby alleviating imbalances in the eurozone economy.

Currency depreciation is China’s main response to US tariffs

When the United States announced it would impose new tariffs on China, the Chinese central bank allowed the renminbi to depreciate. It did this by not intervening in currency markets in order to prop up the value of the renminbi. The United States responded by labelling China a “currency manipulator.” This term is meant to describe a situation in which a country has intervened in the currency market in order to artificially reduce the value of its currency. However, in China’s case, the opposite had happened. The central bank simply stopped intervening in the market, allowing market forces to determine the value of the currency. In fact, the IMF now agrees with this assessment. When the United States said that China is a currency manipulator, it asked the IMF to concur. The IMF has not. Rather, the IMF has issued a report saying that China ought to allow the value of its currency to decline in the face of increased trade restrictions.²² Specifically, an IMF official said that China’s currency is “assessed to be in line with fundamentals.” Another IMF official noted, “If there is a shock, the exchange rate ought to be part of the adjustment and should be allowed to depreciate. That is what exchange rates are for. In principle let the market decide.” The US label is more symbolic than anything else. It sets the stage for the United States to impose sanctions. Yet the tariffs already implemented are far more onerous than any sanctions that could be introduced. Still, the label shook Chinese officials, leading to a quick stabilization in the value of the currency. Now, with the IMF backing up China, it becomes more likely that China will feel it can let the currency fall further with impunity.

It now appears that China’s principal response to the US imposition of higher tariffs is to let its currency fall. In August, the renminbi fell 3.8 percent against the US dollar, the largest single-month decline since 1994.²³ The renminbi is in the midst of a natural depreciation. The only thing that has changed is that the central bank has not intervened to prop up its value. A further decline in the value of the renminbi is expected to partly offset the impact of rising tariffs and help to improve the competitiveness of Chinese exports. Currently, US tariffs on Chinese imports are scheduled to rise in September, October, and December. China has responded by imposing new tariffs on imports from the United States. The Chinese tariffs, combined with a rising value of the US dollar, will significantly hurt US export competitiveness. Given the negative consequences for the United States of a decline in China’s currency, there has lately been talk about the possibility that the US Treasury will intervene in currency markets to cause a depreciation of the dollar against the renminbi or against a broad basket of currencies.²⁴ Doing so would be unprecedented in modern times and would likely spark a political conflict between the two countries. The dollar has lately been strong despite an easing of monetary policy by the Federal Reserve.

Argentina in default

In Argentina, a crisis is brewing largely because of the results of the recent primary election—incumbent President Mauricio Macri, who is held in esteem by the investment community, was defeated by the Peronist candidate, Alberto Fernandez. Fernandez is expected to return Argentina to populist policies if he wins the general election later this year. The election result led to a very sharp drop in the value of the peso as investors sought to take money out of the country. Last week, Macri announced that although the government is not illiquid, he will delay payment on Argentina’s US$101 billion debt. Specifically, he would postpone the US$7 billion payment toward short-term debts. In addition, he would delay repayment on US$44 billion in loans from the IMF.²⁵ The peso and bond values fell sharply on this news. While investors were not pleased, many indicated that this helps to reduce default risk and buys the government time. It also alleviates stress in anticipation of the election. Still, some investors worry that they are being asked to help a president who will likely lose and who will be succeeded by someone that will be less likely to service the country’s debts. Fernandez has criticized the austerity plans of Macri but has not offered an alternative. Argentina’s economy is set to do poorly in the coming year.

Meanwhile, Standard & Poor’s said that Argentina’s decision constitutes a default.²⁶ In the post-war era, Argentina has defaulted on its debts on eight different occasions, including two in this century. That is why investors tend to be wary of Argentine debt, pricing it accordingly. The current default came about because Argentina was not able to sell a sufficient volume of short-term paper to fund repayment on maturing debt. Argentina subsequently chose to postpone repayment. S&P noted, “Following the continued inability to place short-term paper with private-sector market participants, the Argentine government unilaterally extended the maturity of all short-term paper on August 28. This constitutes default under our criteria.” Given that Argentine bonds are priced very cheaply, it appears that investors were already expecting default or something similar. If investors expected the economy to grow at a reasonable pace, then there would be greater optimism about the ability to service debts. It is the lack of growth, driven in part by a lack of investment, that continues to spook investors.

Endnotes

Topics in this article

Economics , Weekly global economic update , Americas Economics , Asia Pacific (APAC) Economics , Europe Middle East Africa (EMEA) Economics , Asia Pacific (APAC) , Europe Middle East Africa (EMEA)

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Dr. Ira Kalish
Chief global economist
Deloitte Touche Tohmatsu Limited
ikalish@deloitte.com
+1 213 688 4765