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Recession fears prompt sharp drop in yields and stocks

By Michael Hewson

Monday’s stock market relief rally rather surprisingly ran out of legs fairly quickly yesterday, with some blaming the differences over the detail between the US version of what transpired at the weekend and the lack of any detail from the Chinese side with which to confirm it.

While it is understandable that there is a certain degree of scepticism about the direction of travel with respect to a quick solution on the differences between the US and China on trade, the speed with which markets moved from this to worries about the prospects for growth is somewhat surprising given that thus far US data still appears quite strong. It’s understandable to have concerns about what might happen in the next 90 days about the prospects for a trade deal given the slightly differing accounts of what happened at the weekend, but to be worrying about a possible recession still seems a little premature.

Yesterday’s sharp slide in US markets was particularly pronounced where the Russell 2000 was concerned which recorded its worst one day fall this year, dropping over 4%, back towards the lows in October and November, while the S&P500 and Nasdaq both recorded falls of over 3% ahead of today’s hastily scheduled market holiday, to honour former President George H.W Bush, as he is laid to rest today.

US bond markets will also be closed, which is probably just as well considering the sharp declines in the longer end of the yield curve, which has seen the gap between the 2-year yield and 10-year yield narrow to its closest level since 2007, to a mere 10 points at one stage.

The 5-year yield on the other hand fell below the 2-year yield, inverting in the process. This shouldn’t happen in an ideal world, and when it does it tends to act as a warning that economic conditions are starting to deteriorate and a recession is on its way, and that longer-term inflationary pressures are likely to remain subdued.

In a normal scenario bond yields tend to rise gradually the further out you go, and this upward gradient, called a rising yield curve, is an indicator that investors think the economy is operating without too many stresses.

Yesterday’s inversion, between the 2 year and 5-year yield, along with the prospect that we could well see the 10-year yield do the same thing appears to have spooked investors, and prompted last night’s heavy falls in US markets, with banking stocks being amongst the hardest hit.

This weakness strikes me as being overdone, particularly when you look at recent US data, however along with concerns about slowing global growth in China and Europe, along with rising geopolitical risk in Europe as well as last night’s events in the UK parliament, its perhaps not surprising that investor nerves are a little frayed.

This investor unease, as well as last night’s sharp falls in US markets is expected to translate into a lower European open this morning.

The pound also slid sharply yesterday, to its lowest level this year against the US dollar after the UK government lost three parliamentary votes, including two contempt of Parliament motions for not publishing the full legal advice on the withdrawal agreement.

The government was also defeated on a motion where MPs forced the government to consult them on next steps should next week’s Commons vote see the withdrawal agreement rejected by parliament. This move more or less takes the prospect of a “no deal” off the table, and that’s even before you consider yesterday’s opinion from the European Court of Justice’s Advocate General that the UK could unilaterally revoke its article 50 notification.

If this is confirmed by the European Court of Justice in a ruling in the coming weeks, it will reinforce the hands of those who want the UK parliament to overturn the referendum result and stay in the EU.

What that would mean for the ongoing political discourse one can only imagine, but it could well poison politics for a generation if it were to happen.

Away from all of this there is the small matter of a raft of economic data due out this morning which will give a snapshot of the services sector in November in Europe and the UK.

While manufacturing has been struggling the services sector has been slightly more robust, though Italy remains a weak spot. Spanish, France and Germany services PMIs are expected to come in at 53.9, 55 and 53.3 respectively with Italy expected to remain in contraction at 49.2.

In the UK the services sector is expected to improve to 52.5 from 52.2, underscoring an economy that is just ticking over.

EURUSD – has thus far failed to move beyond the 1.1500 area and this continues to cap the upside. While below here we could see a retest of the 1.1280 level in the short term, with the potential to revisit the lows earlier in November.

GBPUSD – yesterday’s break below 1.2700 saw the pound briefly make a marginal new low for the year at 1.2657 before recovering. The pound continues to remain vulnerable and a conclusive move below 1.2600 could be the catalyst for a move towards the 1.2000 level and 2017 lows. We need a move back above 1.2840 to stabilise.

EURGBP – the 0.8935/40 level continues to cap advances for now. Still in the broad range and could slip back towards the 0.8820 area in the short term. Above the 0.8940 area argues for a move towards the August highs at 0.9100. Still in the broad range, with support also at 0.8740.

USDJPY – appears to be running out of steam and a failure to move back towards the 114.00 area opens up the risk of a test lower. While below 114.00 the risk remains for a move below the 112.50 level and towards 111.80. The bearish weekly reversal of two weeks ago remains valid while below 114.20.

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