Macro: The Bottom Line (8/18/2014)

What the bond markets are telling us

A mere two weeks after markets ebulliently cheered the 2nd quarter US growth numbers, dark clouds are converging once again. Nowhere has this been more apparent than in the bond markets. Just last week, the 10yr Treasury yield dropped to nearly 2.30 pct, a level it hasn't seen in 14 months. Even more dramatic was the situation in Europe, where Germany now pays less than 1 pct to borrow for 10 years, for the first time in history!

The free fall in developed government yields has to do with two factors. 

First, the growth picture is not all that rosy:

• US: True, the US is experiencing both impressive growth and breakneck job creation. But as we pointed out two weeks ago, there are still several structural issues - such as lukewarm wage growth, sluggish productivity growth, and a lower participation rate - that need to be addressed before we can break out the champagne.
• Europe: Just this week, the EU's statistics agency revealed that the 18-nation Eurozone once again stagnated in the 2nd quarter. Germany, until now one of the few bright spots in the region, contracted 0.2 pct.
• China: China appears to be weathering the challenging macro environment well, maintaining 7-plus pct growth amid improving sentiment indicators. But it's worth remembering that this can be attributed in large part to the government's mini-stimulus - including incentives for banks to extend more credit. Such measures do assist growth in the short run, but at the cost of exacerbating China's already elevated levels of private-sector debt.
  

Second, geopolitics continues to rear its ugly head, with three regions (Ukraine, Israel/Gaza, Iraq) all convulsed in a seemingly endless conflagration. And even more so, the conflicts appear to be striking closer to a point where they could have global economic implications. This has especially been the case in the Ukraine conflict, where a tit-for-tat sanctions war between the West and Russia has already taken hold. With Russia now banning imports of key food items from the EU and the US, the agricultural sector in several European countries is already feeling the pain. The risk is that the sanctions spiral sucks in other sectors that account for an even greater share of employment and output in these countries. Not to mention the risk of energy-supply disruptions and higher utility bills in the EU. 

Of course, both these factors may ultimately prove to be transitory. But they are a sobering reminder that we are a long way away from the rosy days of pre-2008.