Trouble with the curve

Published at 14:16 29 Mar 2019 by . Last edited 11:18 22 Aug 2019.

The collective gasp that you probably heard early in the week was triggered by the inversion of the shorter end (the very front part) of the Treasury yield curve. The 3-month treasury bill now yields more than the 10-year Treasury for the first time since 2007. For many, especially those in the bond market, a yield curve inversion has been a harbinger of recessions in the past, with a few notable exceptions. The most recent exception was in 1997-98, when the curve inverted only briefly and a recession didn’t materialise. The similarities between 1998 and today are compelling. Back then, emerging markets were in turmoil, much of it currency driven, coupled with—and to some extent driven by—a large slowdown in global trade. This is very similar to what we have seen in the past year or so with the US/China-driven slowdown in trade and a stubbornly strong dollar.

But for all the consternation over the yield curve, we have not yet seen clear signs of stress that would confirm a recession is looming. There is certainly a slowdown underway and that is reinforced by the very mixed data out of the US, Europe and China. Moreover, it is not just an inversion in the shorter end of the curve that matters, but also the longer end—specifically the spread between the 2-year and 10-year treasuries. And, if anything, that part of the curve is steepening, as the spread between the 10-year and 30-year treasuries is getting wider.

Lastly, though the bond market has not rallied with equities so far this year, it has not demonstrably weakened either. Corporate spreads for both investment grade and high-yield remain ‘calm’, which suggests that the broader bond market is not yet freaking out. Again, this is not to say that everything is hunky dory, but it is also not indicative of severe stress in the financial system.

The dollar
The biggest challenge we see right now for markets, which could potentially lead to that distress, is the dollar—and there are many reasons for its strength. The flattening of the yield curve at the front end, coupled with weakness in the rest of the world (Brexit, China, Europe), continues to spur demand for the dollar because money wants to be in the US so badly that it is willing to do so unhedged. Japanese and European investors have either been pushed down the risk curve—forced to buy high-yield securities—or they are buying more US treasuries without hedging the dollar (which strengthens the greenback). Hedging is more expensive when the curve is flat, so if the curve steepens, it may spur hedging, which is why we are interested in the steepening of the longer end of the curve. A steepening yield curve will likely be pricing in Fed rate cuts and it will allow currently unhedged dollar risk to hedge by selling dollars. A steady slew of Fed officials have come out this week and suggested that it is premature to start pricing in rate cuts. But if indeed the Fed does ease, and the longer part of the yield curve steepens further, then this will have implications for the dollar.

Another reason that the dollar bullishness may be fading is that US companies have been repatriating capital following the tax changes enacted in late 2017, which according to the Department of Commerce has resulted in the repatriation of over $600 billion to the US, which then fuelled a surge dividend payments in 2018. This pace of repatriation is roughly three to four times the annual rate of the past decade. Since the massive jump in Q1 18, the volumes of repatriated capital have been steadily falling and should normalise going forward.

Fig 1: US home sales vs 30 yr mortgage rate Fig 2: US Dividends and Withdrawals, $bn
Source: Bloomberg, Energy Aspects Source: Department of Commerce, Energy Aspects

So, broadly speaking, the main reasons for the surge in the dollar were the repatriation of US capital due to the tax change, along with the Fed hiking rates while simultaneously trying to reduce its balance sheet, which basically combined to suck capital out of emerging markets and back to the US. This massive flow of capital could change directions again, potentially with dollars mobilising out and away from the US and into other areas. This would be the most important signal in the coming weeks for risk assets.

One other factor to consider is that the US remains the cleanest dirty shirt in the closet. As the rest of the world continues to struggle, the US is still attractive on a rates, yields and relative value basis. In this sense, the dollar remains a safe haven asset and so these forces will be difficult to flip.

Moreover, unless the rest of the world begins to outgrow the US, then the structural forces supporting the dollar could intensify going forward, especially if growth rebounds first in the US as we expect. This turnaround largely reflects a rebound from the government shutdown and the polar vortex adjustment issues in US GDP. But there are other signals as well. In particular, some of the pick-up we are seeing is concentrated in sectors that should benefit from easier financial conditions, especially housing. Notably, the uptick in US existing home sales has coincided with an easing in the 30-year mortgage rate, which coincided with the decision by the Fed to pause rate hikes. Housing is still very important for the broader US economy.

Brexit and China
As we noted earlier we still expect to see a pick-up in activity in H2 19, led by the US, but there are other areas we are watching closely. China, as we have previously discussed, should start to see the impact of the stimulus show up in the data from late Q2 19 onwards. To be sure, some of the more recent data do not inspire much confidence that the slowdown in global growth is bottoming, but there are some signals that give hope. Any improvement in Europe would do wonders for sentiment in the coming quarters. Brexit and the US-China trade dispute are weighing heavily on the global economy, but Europe is suffering directly from both. 

It is Germany which has seen the biggest decline in manufacturing activity globally. But, notably, the German manufacturing data have been a relative outlier among the European PMIs. Moreover, the service sector readings look much better both in Germany and elsewhere in the Eurozone. Reinforcing this view, the ZEW Economic Sentiment Index has moved higher in recent months. With easier fiscal policy and a strong labour market, Germany will be in a very good position should there be a rebound.

Fig 3: Manufacturing PMIs (SA) Fig 4: Zew expectation of economic growth
Source: Markit, Bloomberg, Energy Aspects Source: Zew, Bloomberg, Energy Aspects

As for US-China trade talks, Trump continues to tweet positively about the prospects for a deal—whatever that may mean. The most recent timeline now puts a Trump-Xi summit sometime in June. Steven Mnuchin and other US officials are currently negotiating and there is still a belief in administration circles that something will be agreed in June, which suggests that some of this uncertainty will become less uncertain by the end of Q2 19.

A very British omnishambles
However, any clarity on the outcome of Brexit remains stubbornly elusive. Theresa May, having (at the time) twice failed to win parliamentary support for her Brexit deal took the extraordinary step of promising to resign if UK members of parliament (MPs) supported the plan. Meanwhile parliament failed to back any of the eight alternatives proposed in a series of indicative votes on Wednesday evening. Behind all the political drama, the UK is running out of ways to try and agree an approach to Brexit, or even narrow down the range of options, despite almost three years having passed since the referendum. Brussels has already agreed to extend the Article 50 deadline, but only until 12 April if May’s deal is not approved by the UK parliament. The UK government is meant to use the next two weeks to come up with an alternative approach that convinces the EU, at a summit that is being set for 10 April, to agree to a longer extension of the Brexit deadline for a whole new round of negotiations. But after events this week that will be a tall order.

Two weeks may prove not to be a long time in politics, particularly if Westminster is preoccupied by questions of who will succeed Theresa May. A leadership contest within the ruling Conservative party or a general election in the coming months look almost inevitable. Theresa May's deal was again defeated for a third time today, still by a substantial margin, likely putting it to rest for good. MPs will now spend Monday debating some of the alternative options again. The alternatives defeated by the smallest margin on Wednesday (27 March) related to a softer form of Brexit and a second referendum. But many Conservatives, including several of the frontrunners to replace May as leader, want a hard Brexit, which creates new complications. If Brussels agrees to extend negotiations, it could find itself working with a new UK prime minister who is less supportive than May for the EU’s vision of a soft Brexit. Despite the rotten tomatoes, Brexit is unlikely to get cut by the news networks and looks set to remain on screen for at least a few more seasons.

End of quarter
This Friday (29 March) is the last trading day of Q1 19 and, as such, some of the best performers so far in Q1 19 have come under pressure over the course of the past week. Part of the reason is that the relative outperformance of equities, crude and gasoline will force some funds to rebalance to maintain the mandated weightings in their portfolios. There is therefore an expectation that some funds will need to lighten up on some of the better-performing assets.

Between end-of-quarter rebalancing and the ramping up of the buyback blackout period (see Digest: Kick the can, 15 March 2019), there could be some renewed pressure on equities over the next two weeks. This matters because, since December 2018, flat price Brent has been more closely correlated to the S&P than the prompt Brent spread. In fact, it has been one of the longer stretches where oil and equities have been so closely correlated. We have been surprised at how little uplift flat price has seen despite the continued tightening of broader crude fundamentals in the last two months. Perhaps this correlation to equities is one of the reasons why oil has not rallied materially, and, for crude to rally, perhaps that linkage between crude and equities needs to break first.

Fig 5: Brent ($/b) vs S&P 500 index Fig 6: Risk assets Ytd performance (%)
Source: Bloomberg, Energy Aspects Source: Bloomberg Energy Aspects

The Outlook
Brent: The prompt spread rallied hard into expiry this week as demand from Asia and strong local margins spurred buying interest. Chinese refiners turning bullish and buying in size should bode well for North Sea grades. However, margins may come under seasonal pressure and so the outlook is a little more mixed in the near term, even as we remain structurally bullish Brent due to OPEC discipline, continued sanctions on Venezuela and Iran, and IMO-driven demand for products. Brent bulls are hanging their hats on June Ekofisk maintenance, while bears argue that eastern crude is now more advantaged given the recent rally which, coupled with US arrivals, will be enough to pressure Brent spreads. But US loaders to Europe should stay low in April. If Asian demand for North Sea barrels wanes, then it would be hard to maintain the strength in spreads. This is important as bullishness and bearishness in benchmark spreads is being expressed via arbs. Thus, as WTI has tightened, so too has the WTI Brent spread. Brent will still need to lead and pull WTI barrels out of the US. If Brent spreads continue to tighten, this could pressure the arb, forcing longs onto the sidelines. Given our expected strength in Brent this summer, even as WTI tightens, there is a formidable near-term risk of WTI-Brent widening out again as a constructive summer Brent market gets underway.

WTI: Timespreads rallied with the contango in the very prompt part of the WTI curve narrowing, as cash WTI jumped into backwardation this week. This was driven by disappointing Cushing builds amid quality issues and with pump-over congestion impacting individual tank farms at delivery (for more details, see our data review: US Department of Energy, 27 Mar 2019.). Tighter specs at Cushing and midstream enforcement of quality segregation appear to have left the delivery point short of on-specification WTI material, while complications surrounding pump-over capability among specific tanks complicated expiry further. While we still expect to see Cushing builds in April and May, the Cushing outlook should grow increasingly constructive from June, but only after a period of consolidation among WTI instruments during Q2 19. Given our expectation of Brent strength, there is scope to see another widening of WTI-Brent spreads in the near term. But, as Permian takeaway capacity increased earlier than expected and incremental Canadian supply has been delayed by up to a year, Q4 19 is lining up to be supportive of WTI timespreads (see more details in North America Quarterly, March 2019). We would expect to see full backwardation in WTI timespreads by Q4 19, and any weakness in Q4 19 timespreads and/or the WTI-Brent spread could offer good entry points for those wishing to reload on both.

Fig 7: Prompt benchmark spreads, $/b Fig 8: WTI crude curve, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Products: A string of refinery outages has flipped the narrative on products pretty swiftly. Gasoline has strengthened materially as all the light products in the world will not matter very much without octane, which is helping to support gasoline. In fact, despite the poor performance in Q4 18, gasoline has been among the strongest-performing assets in Q1 19. Even though we still think OECD demand growth will be weak and supply will be robust, largely due to the shift in the global crude slate towards lighter barrels, the loss of octane due to planned and unplanned outages has changed the equation for summer gasoline, which should remain strong for a while longer. Meanwhile, seasonal headwinds in diesel have kept the ICE gasoil prompt in contango even though inventories remain low. With low Rhine river levels again in focus this month, there is renewed pressure on cash distillate barges in Europe. Seasonally, this should keep pressure on gasoil, though we do expect to see improvement as we move into the summer. Our view over the next six months vis-à-vis both gasoline and distillate remains unchanged even if the nearer term will not reflect it.

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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