As global uncertainty accelerates around the world, constantly lowering growth expectations, global yields have been plunging since the end of last year with the 10Y US down from 3.2% in early November to 1.6% on Friday. We saw that global sentiment has been significantly deteriorating with the global manufacturing PMI index plunging below the 50-line threshold that separates growth from contraction. Figure 1 (left frame) shows that the global PMI has been strongly co-moving with the 10Y yield in the past cycle. We also saw that global defensive stocks have outperformed cyclicals in the past 18 months and show a strong relationship with the 10Y yield as well (figure 1, right frame). It is important to note that January 2018 was the peak of many equity markets (i.e. Japan, EM…) and that the US dollar strength is not pricing in any signs of recovery in the short run.
With copper prices down over 20% since the beginning of 2018 and gold breaking new highs amid a surging amount of negative-yielding debt (figure 2, left frame), the copper-gold ratio has also been plunging. The little divergence we saw in the first half of 2018 was eventually followed by a sharp decrease in the 10Y yield, which eventually converged back to its "fair" value this year (figure 2, right frame).
Net speculative shorts on copper are now standing at the highest level on the back of a large increase in shorts in recent months (figure 3, left frame), implying that market participants have been betting on the industrial metal prices to plunge as the probability of a recession increases. Figure 3 (right frame) shows that copper is now approaching its long-term upward trending support; if it breaks lower, the next support will be the psychological level 2. Therefore, if we assume that gold prices remain constant as the amount of negative-yielding debt stagnates, weaker copper would imply lower US yields based on the copper-gold vs. US 10Y relationship. After five years of bear market, the 2016 reflation trade levitated copper prices as Chinese credit conditions eased, which pushed copper prices by over 60% between August 2016 and December 2017. We saw previously that the Chinese credit impulse, expressed as the annual change in Total Social Financing (TSF), has strongly co-moved with copper and the Aussie (both considered as leading indicators) since 2004.
It does not seem that we are on the way of experiencing another 2016 reflation trade scenario within the next six months, hence we think that copper weakness will continue.
Market participants will be closely watching the next FOMC meeting if US policymakers start to express any sign of concerns on the current economic environment. Even though the trend on global bond yields could persist in the medium to long run as uncertainty continues to increase, we actually think that we could see a short-term consolidation on US LT yields. US real GDP growth came in at 2.3% in the second quarter of this year and is expected to decelerate to 1.5-2% in Q3; we do not deny the slowdown, but we are still far from a recession in the US. Economic data have also been improving in the past two months despite the trade war dispute; the Citi economic surprises index is up from -68 in late June to 8 on Friday.
Overall, we think that US yields have plunged too much (and too fast) relative to other major economies and we would expect a little consolidation on the 10Y in the coming weeks despite copper looking vulnerable. We do not expect a 50bps cut at the next meeting as we think that Powell could send the market a wrong signal by doing so. In addition, if uncertainty stabilises this quarter, it should also push participants away from bonds in the short-term. Figure 4 (right frame) shows that the rise in uncertainty (EPU Global) has been strongly associated with lower yields; hence, if the annual change in the EPU starts to decrease, US LT yields should rise.
Disclosure: I am/we are long GBP. 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.