A Perfect Inverse Correlation: As Yields Move Down - The Odds Of A Recession Move Up

by: The Fortune Teller

It's a very gloomy ending for a volatile week in Europe, with a slate of negative news coming the UK, Netherlands, Germany, and Italy.

While the Italian turmoil in Italy is sending yields up in the boot country, it's causing the opposite effect in Germany and the US.

Unsurprisingly, the high level of uncertainty is also pushing the likelihood for a recession over the next 12 months up too.

What a lovely morning is it today - Friday, August 9th - in Europe (VGK, EZU, HEDJ, FEZ, IEUR, BBEU, IEV):

The UK (EWU) economy contracted by 0.2% during Q2/2019, for the first time in seven years (last time: Q4/2012)

Netherlands (EWN) industrial sales fell a whopping 10.2% in June, the most in almost 10 years!

And of course, there's a new political turmoil in Italy (EWI), again.

Italy's 10-year bond yield spikes 20 basis points as Salvini aims for new elections.

Indeed, too much time (in Italian terms) has gone since the last elections, so apparently, some of the major figures wish to have another one.

Needless to say that the political turmoil also pushes Italian bank stocks markedly lower. As I type this, the FTSE Italy Banks Index is down 3%, while Italy 10-year yields are rising, after the leader of the ruling League party, Salvini, pulled his support for the country's governing coalition.

However, while in Italy, the "doom loop" prevails (again), sending default probabilities of Italian debt and banks up in tandem...

...it's a completely different picture in Germany (EWG), the US (SPY, DIA, QQQ, IWM), from a yield perspective.

So much so that one has to wonder whether Germany in on course for a recession?

German trade data for June disappointed, making a contraction in Q2 more likely. Exports have dropped by 0.1% in June M/M and 8% Y/Y, following a 1.3% M/M rise in May, bringing trade balance to €18.1bn in June.

As a result of this, as well as everything else that goes on in Europe, German Bunds yields are digging new holes, almost daily.

In light of the news - on both political and economic fronts - German 10-year yields drop to -0.59%

Meanwhile, in the US, the Trump administration is reported to be holding off from approving licenses for tech companies to sell equipment to Huawei.

But even before this news broke out, investors jumped (yesterday) into the ultra-low yield offers by the US Treasury on its new 30-year debt sale.

The auction drew a yield of 2.335%, which is the lowest closing level (for this tenor) since 2016. It was a little more than 1 bps above the (then-prevailing) market rate, but the "tail" (= difference between highest and lowest bids) was narrow (<1 bps), and (external) investors only kept some "leftover" for primary dealers, both these parameters indicate that demand was strong.

With such low yields among two of the world's largest - and surely most dominant - economies, and as global trade and currency tensions fuel economic uncertainty, it's no surprise that the odds for a recession keep rising.

According to the most recent survey of economists, the likelihood of a US recession over the next 12 months is now 35%.

The 35% probability in the August survey is up significantly from the 31% that economists assigned for a recession in July.

As the odds for a recession are rising, investors might wish to start thinking about fine-tuning their investment strategy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.