Financial media loves to focus on the flattening yield curve right now.
Based on the current rate of flattening, some analysts expect the yield curve to become inverted by mid-2018. Historically, an inverted yield curve is a leading indicator for significant corrections, bear markets, and recessions.
I disagree with these analysts. I don’t think the yield curve will become inverted in 2018. Here’s why.
*The U.S. stock market usually goes up when the yield curve is flattening. The yield curve is a medium-long term bearish sign for stocks if it becomes inverted.
The yield curve will not invert in 2018
For starters, many years can pass between “almost inverted” to “actually being inverted”. For example, the yield curve was almost inverted by 1995. It did not become inverted until 1998. The bull market ended in 2000.
Several factors suggest that the yield curve’s rate of flattening will slow down, which means that the yield curve will most likely become inverted in 2019/2020 instead of 2018.
Bloomberg initially reported that unnamed Chinese officials recommended slowing down or halting China’s purchases of U.S. Treasury bonds. China later denied these rumors. However, China’s denial is a bold lie.
No matter what China says, China needs to stop buying U.S. Treasury bonds. They have no choice.
China wants to diminish the U.S. dollar’s power in global financial markets. To do that, they need to establish the PetroYuan, which will be backed by the gold standard. This means that China needs to buy a lot of gold first.
You can see from this chart that China is secretly stockpiling gold. China doesn’t update its “official” gold reserves very often. But every time China updates its reserves, the official reserves SPIKE.
There is no way to estimate China’s true gold reserves. Many believe that China’s true holdings are considerably larger because a lot of gold from local Chinese mine production is bought by the Chinese government (i.e. there is no way for the international community to verify those purchases).
China needs to spend hundreds of billions on gold if it is to establish the PetroYuan via a gold standard. China’s current holdings are minuscule compared to other countries (the official number at least).
China faces a problem. It does not have enough cash to buy massive amounts of gold right now. China has already spent a lot of its foreign currency reserves on defending the Yuan from 2015-2016.
Out of the $1 trillion decline in forex reserves, less than $500 billion of that came from selling U.S. Treasuries.
This means that China used a massive combination of other assets and cash to defend its Yuan.
Hence, China’s central government is probably cash-poor. If China wants to establish the PetroYuan on a gold standard, it needs to dump hundreds of billions of dollars worth of assets and raise cash. What’s the best asset to sell? U.S. Treasury bonds!
Everyone knows that U.S. interest rates are going up in the long term. Now is the perfect time to start selling U.S. Treasury bonds (or at least let China’s existing Treasury bonds mature without rolling over).
A lack of Chinese buying in the future is a long term bullish factor for long-term U.S. Treasury rates (e.g. 10 year, 30 year). Most of China’s Treasury holdings are in the long end of the curve.
Sentiment and mean reversion.
Traders are extremely crowded in the yield inversion trade.
So from a pure mean reversion perspective, you can expect the yield curve to steepen a little before it slowly flattens and becomes inverted. This means that the yield curve will become inverted at a later date than many analysts expect.
Big funds are moving out of bonds
Big bond funds are going from long bonds (bearish on rates) to short bonds (bullish on rates).
- Jeff Gundlach expects interest rates (10 year) to rise in 2018. When Jeff Gundlach says that he expects rates to rise, he is already short long term bonds. He’s simply talking his own position and hoping that copycats will push his trade even more!
- Likewise, Bill Gross now believes that bonds are in a bear market.
Everyone is looking at the 3% level on the 10 year yield. Popular belief states that yields will not look back once the 10 year yield breaks above 3%.
The new Fed chairman is dovish
Incoming Fed Chairman Jerome Powell is a dove. The market expects 3 rate hikes in 2018. I’m not sure the market will get what it expects.
- Powell has a track record of being dovish, so he’ll probably deliver fewer rate hikes than the market expects.
- Powell is new to the job. Nobody who’s new to a job wants to mess up during his first year. Hence, Powell would rather err on the easy money side than the tight money side.
If Powell hikes rates less than expected, then short term rates won’t rise as fast as they are rising right now. This will slow down the rate of the yield curve’s flattening.