22 Oct TRADE AND THE TREASURY MARKET
Many times I have commented about the lack of liquidity in the markets, the result of regulatory fiat, changes in market trading structures and the massive move to passive investing.
Yesterday both Goldman Sachs and State Street echoed similar concerns, stating the issues in the repo market are perhaps the proverbial canary in the coal mine. Both firms cited the systemic risk is partially the result of the end user of liquidity is now the customer who historically disappears in times of volatility.
In my view State Street’s warning is significant given that they are one of the largest custodians of ETFs.
In times of volatility, State Street and its customers may need to rely upon credit lines to meet ETF liquidation requests. Such requests have caused several marquee European and South Korean investment firms to cease operations. [Note: These failures are the result of liquidity mismatches and illiquid investments]
A possible catalyst for such difficulties could be higher interest rates. The bond market has discounted a recession. The recessionary narrative is beyond fevered, the result of trade issues. What happens if the narrative is wrong?
According to Bloomberg analytics, if the 10-year Treasury increases in yield to where it stood on January 2, 2019, the 10-year would have a negative 22.24% total annual return.
Wow! The risk free benchmark would be crushed.
In my view, from the perspective of US economic growth, the relationship with China is receiving too much attention. Even before the trade dispute started, US exports to China were a smaller share of GDP than exports to Japan before the Japanese economy imploded in the early 1990s.
I vividly recall reading stories similar to the ones written today about China. The US economy did very well.
Many have attempted to compare today to the 1930s. According to Dow Jones, US merchandize imports dropped 70% from 1929 to 1932 and exports dropped 69%.
By contrast, even before the recent trade deals with Mexico, Canada and Japan being implemented US trade with the rest of the world has been rising. Dow Jones reports in the past 12 months, exports and imports combined have been $5.65 trillion versus $5.63 trillion in calendar 2018 and $5.26 trillion in 2017 and $4.93 trillion in 2016.
In other word even without deals, trade would be hitting record highs this year.
The economic uncertainty is based on trade. What happens to the bond market if this uncertainty is removed or if the reality that I have just penned becomes the prevailing narrative?
Perhaps we will discover if State Street’s and Goldman’s warning were indeed valid.
Commenting about yesterday’s market action, equities advance on trade optimism. Earnings season accelerate today and results to date have been regarded as “mixed.”
Last night the foreign markets were up. London was up 0.37%, Paris up 0.03% and Frankfurt up 0.22%. China was up 0.50%, Japan up 0.25% and Hang Sang up 0.23%.
The Dow should open flat ahead of numerous earnings. Trade optimism is also rising. The 10-year is up 6/32 to yield 1.78%.