The flattening US yield curve has been, to some commentators, an early omen of an inversion. In turn, an inverted yield curve often portends a recession with remarkable reliability. At the very least, it would suggest that investors lack confidence in the prospects of the US economy, which is surprising given the current economic data. However, such fears are unjustified. Nevertheless, it is one of the most important and widely-discussed topics in financial markets.
Risks and Rewards
To begin, the Treasury yield curve measures the spread between short- and long-term debt issued by the US government. It is the ‘term premium’ that investors demand to lock away their money for an extended period. Lending money over a longer period is inherently riskier. Therefore, investors require more reward for accepting such default risk.
For context, the US economy is currently showing remarkable dynamism and is experiencing its second-longest growth spell on record. The unemployment rate has continued to trend lower since August, dropping from 4.4% to 4.1% in October. This is paired with buoyant consumer confidence. The Conference Board Consumer Confidence Index hit 129.5 in November, its highest reading since November 2000. Clearly, the US economy is energised.
Meanwhile, inflation remains stubbornly low, with core consumer prices, which strips out food and energy prices, below the Federal Reserve’s 2% target. Crucially, the Fed has developed a reputation as an inflation fighter over the last few years and has gained credibility in the bond markets through executing its planned rate hikes. Such credible monetary policy is probably suppressing the yield on longer-dated treasuries which are more sensitive to inflation expectations and economic growth than short-dated bonds. Conversely, shorter maturity bonds tend to be more sensitive to short-term interest rate expectations.
Short and Long Term
The two-year US Treasury yield is over 1.75%, driven by 25bp rate hike expectations at the next FOMC meeting on December 13th and beyond into 2018. Meanwhile, the key driver behind the flattening has been a reduction in the term premium on longer-dated bonds. This is bringing the yields of short- and long-term bonds closer to each other. Hence the phrase ‘flattening’ of the yield curve.
It could be argued that a precise set of circumstances means that the bond market may have entered a ‘new normal’ and that the predictive power of the yield curve is diminished. For example, the yield on longer-term maturities is probably being influenced by the aforementioned weak inflation expectations.
Supply and Demand
There are also several other forces that might be at work here. Supply and demand forces may be behind the fall in longer-term yields. Passive mutual funds such as Vanguard and BlackRock have increased their demand for longer-dated Treasuries, creating extra demand and thereby lowering yields.
Meanwhile, supply forces from the Treasury are also shaping the market, with the Treasury recently announcing that it wants to focus on issuing shorter-dated maturities, creating a shortage of supply. Finally, the trillions of dollars’ worth of central bank stimulus built up over the last few years continue to put enormous pressure on bond yields. The European Central Bank, which is tapering its asset purchases by less than markets expected, has driven a wedge between the 10-year US and German yield with ultra-loose monetary policy, thus creating an incentive to invest in American debt. It has also focused its asset purchases on longer-dated debt.
Regardless of the exact reason behind the flattening of the yield curve, it does not appear probable that a recession in the US is imminent. It is likely that the yield curve will continue to flatten in 2018 in the absence of a pick-up in inflation.
Breakfast Briefing: Space Race, Google in China and Zuckerberg
Google to Open in Beijing
Alphabet announced that it will open an AI research facility in the Chinese capital yesterday.
Editor’s Remarks: Under CEO Sundar Pichai, Google has been recommitting itself to China after it had most of its services blocked in 2010 when it refused to censor search content. In recent months, the tech giant has been marketing its new TensorFlow AI tools to the Chinese market, which aligns with the state’s ambitions to become a world leader in AI by 2030. Google’s new facility will consist of a small number of AI researchers, supported by hundreds of Chinese engineers. Google expects to face stiff competition for talent given how local tech giants, Baidu and Tencent, are ramping up their own AI efforts.
Telegram Is Not for Sale
Telegram’s elusive founder, Pavel Durov, insists that his messaging service will remain non-profit.
Editor’s Remarks: Durov and his brother Nikolai founded VK, Russia’s answer to Facebook, before they were forced to sell their stakes to a Kremlin-friendly oligarch. The pair has since relocated and built Telegram, an encrypted messaging service that they insist will never be sold. A libertarian – having enabled Telegram users to even send messages that will self-destruct – Durov and his product have gained popularity among cryptocurrency enthusiasts. Durov himself is bullish about the prospects of cryptocurrencies and owns at least 2,000 bitcoins. Pundits, meanwhile, reckon that Telegram is worth in the region of $5bn.
Japanese Space Startup Raises $90m
Ispace Inc raised $90m from Japan’s largest corporates in a bid to reach orbit by 2019.
Editor’s Remarks: Ispace is backed by Japan Airlines, Tokyo Broadcasting System Holdings and also government-backed Innovation Network Corp. of Japan. The company plans to sell advertising space on its spacecraft, which will then feature prominently in distributed images. However, Ispace also envisages the use of rovers that will offer a “projection mapping service”, which will essentially produce a tiny billboard on the surface of the moon. This is the latest announcement in what is rapidly shaping up to be a wider commercialisation of space exploration. Elsewhere, SpaceX and Blue Origin are developing reusable rockets, while Planetary Resources intends to mine asteroids.
Roy Moore Loses Alabama
Moore, who was backed by Trump, narrowly lost to Doug Jones, a largely unknown Democrat.
Editor’s Remarks: Moore’s election efforts appeared to have succumbed to allegations of child abuse that were made against him last week. Newcomer Jones won 49.9% of the vote against Moore’s 48.4% in deeply conservative Alabama, marking the Democrats’ first Senate victory in the state since 1992. Moore is a household name in Alabama but the accusations recently levelled against him have ruined his once impeccable reputation. Reluctant to concede defeat in his home state, Moore has said that Alabama must “wait on God and let the process play out”. Meanwhile, Democrats are jubilant that they have managed to reduce the Republican majority in the Senate to 51-49, which could impact Trump’s tax reform.
Zuckerberg Backs VR Firm
Dreamscape Immersive, a virtual reality (VR) company, is backed by 21st Century Fox, Warner Bros. and Mark Zuckerberg.
Editor’s Remarks: Dreamscape is developing new VR arcades for shopping centres and has just closed a $30m Series B funding round – 50% more than planned. Among its initial backers were Steven Spielberg, 21st Century Fox and Warner Bros. The company has now added to that impressive list the likes of Mark Zuckerberg and Nickelodeon. Dreamscape is capitalising on Hollywood’s interest in VR, which the film industry reckons will draw in greater numbers of viewers and provide an opportunity to raise margins. Dreamscape intends to open seven VR centres in locations across North America and the UK.
Google to Open Artificial Intelligence Centre in China
Google will be opening its first artificial intelligence (AI) research centre in China, despite many of its services being blocked there.
Fei-Fei Li, Chief Scientist of Google Cloud, said:
“I believe AI and its benefits have no borders. Whether a breakthrough occurs in Silicon Valley, Beijing or anywhere else, it has the potential to make everyone’s life better for the entire world. As an AI first company, this is an important part of our collective mission. And we want to work with the best AI talent, wherever that talent is, to achieve it.”
The research centre will focus on basic AI research, and will consist of a team in Beijing, who will be supported by Google China’s engineering teams.
Google’s search engine and its Gmail are banned in China. However, the country has 730 million internet users, making the market too large to ignore.
Google is not the only tech giant facing restrictions in China. Facebook is also banned, while Apple’ App Store has been subject to censorship. In order to comply with government requests, Apple removed many popular messaging and virtual private network (VPN) apps from its App Store in China earlier on this year.
China has recently announced plans to develop artificial intelligence, and wants to catch up with the US. However, human rights groups are concerned by China’s use of artificial intelligence to monitor its own citizens.
Europe Warns Trump on Tax
Finance ministers from Europe’s largest economies have said that Trump’s tax plans breach global agreements.
Europe’s leading finance ministers, including UK chancellor Philip Hammond, penned a letter to the White House in which they raised the possibility of retaliation if the Republicans push on with their tax reforms. Europe is worried that Trump’s “America First” doctrine will undermine global trade patterns and escalate ongoing tensions between the US and its key allies. With the UK looking to its closest ally for support post-Brexit, it is unlikely that Hammond’s latest move will sweeten any future US-UK trade deal. Meanwhile, Trump is unlikely to care about shaking up current trading arrangements, given that he ran for office on the platform of making the US more competitive.
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