Understanding the economic cycle of U.S. manufacturing and its relationship to foreign manufacturing cycles best explains how to forecast both short- and long-term interest rates on government bills and bonds. In a recent article, IDC Financial Publishing (IDCFP) explained the relationship in manufacturing cycles between key countries. In summary, tariffs on China caused a chain of events that led to a decline in U.S. interest rates and the current positive yield curve of U.S. 2- versus 10-year T-Notes.
The tariffs on China impacted consumer confidence and discretionary spending, in particular the spending cycle in vehicle sales. Chinese monthly vehicle sales fell from 3.06 million units in December 2017 to cycle lows of 1.7 million units in 2018 and 1.4 million units in 2019.
China is Germany’s largest customer of exported manufactured goods. Germany’s exports account for 47% of their GDP, and the majority are manufactured goods. The reduction in Chinese purchases was measured in Germany’s manufacturing cycle by the German PMI, which declined to 41 in September 2019, down from its peak of 65 at year-end 2017. In reaction, the Bundesbank reduced, through asset purchases, the yield on 10-year bunds from +60 basis points in 2017 to a low of -71 basis points in September 2019.
Since Germany is the largest foreign buyer of U.S. manufactured goods, the U.S. manufacturing cycle collapsed in 2019. U.S. manufacturing PMI declined to 48 by September 2019, from its peak of 59 at year-end 2018. In response to the drop in the. PMI, and dramatic shift in German yields from positive to negative levels, the U.S. 10-year yield plummeted from 3.2% in November 2018 to 1.47% by September 4th, 2019.
To better understand the indicators that forecast the peak in yields in 2018, we analyzed the yield spreads between U.S. and German 3-month and 10-year bonds. U.S. less German yields of both maturities paralleled each other from mid-2017 to September of 2018 (see Chart I). However, the rise in the U.S. 10-year yield to 3.24% on November 8, 2018, while the German 10-year was 46 basis points, widened the spread to 278 basis points. Additionally, the federal funds rate increase to 2.5% at year-end 2018 widened the spread of the U.S. 3-month T-Bill to the German 3-month bund to 342 basis points, dramatically above the 10-year spread (see Chart II).
The “rubber band” was stretched to the breaking point and has snapped back. By November of 2019, the two spreads are again equal or normalized as they were in 2017 and 2018.
- The 10-year U.S. less German spread declined sharply, from 278 basis points in late 2018 to 209 basis points on October 31, 2019.
- The U.S. T-Bill 3-month spread collapsed, going from a peak of 342 basis points at year-end 2018 to 213 basis points at the end of October, as the Federal Reserve reduced the funds rate a third time to 1.75%, correcting the rate hike error that occurred in 2018 (see Chart II).
There has been resolution of the first phase of tariff negotiations between the U.S. and China, and there is potential for a second phase. Chinese vehicle sales are amid a reversal, reaching 2.27 million units in September, or an annual rate of 27.6 million units, above the current 12-month unit sum of 26 million. Chinese consumer confidence has improved, increasing discretionary spending with potential vehicle sales climbing back toward an annual rate of 30 million units or more.
The manufacturing cycles in Germany and the U.S. reached lows in September and are improving. The German 10-year yield recovered from a September 2019 low of -71 to -23 basis points in November, and the 3-month German bund bottomed out at -73 and increased to -59 basis points. Both were a result of Bundesbank action.
German Yields Continue to Control U.S. Yields
Historically a normalized yield curve occurs when the 3-month German yield spread equals the 10-year spread (see Chart I). Even when the 10-year bunds increase toward positive yields, German short-term rates remain around a negative 60 basis points.
Given the future relationship between yield spreads of 10-year U.S. bonds and German bunds remains stable, and equal to short-tern spreads, as the Bundesbank raises the 10-year German yield in response to manufacturing cycle improvement, U.S. yields will increase.
While the U.S.-German yield spreads remain between 210 and 220 basis points, a German 10-year yield of -30 basis points indicates a 1.71% to 1.9% U.S. 10-year yield, and a German 10-year of -20 basis points forecasts a 1.9% to 2.0% yield. A recovery in the German 10-year bund yield to zero basis points forecasts a 2.1% to 2.2% yield on the U.S. 10-year T-Note.
Rising U.S. yields on the 10-year and a steeper yield curve in U.S. Treasuries reflect recovery in the Chinese auto cycle, German manufacturing PMI, as well as U.S. PMI in 2019 and into 2020. A major event resulted from change in U.S. yields in 2019, going from a negative yield curve (an indication of recession), to a positive slope. That reversal created a sharp improvement in the performance of U.S. bank stocks and is a good omen for increased economic growth.
John E Rickmeier, CFA, President, firstname.lastname@example.org
Robin Rickmeier, Marketing Director