The Daily Prophet: There’s a Bull Market in Political Crises

Emerging-market assets have been so strong in recent months that some investors were quietly talking about them in terms of being havens from the turmoil gripping developed-market politics. In fact, emerging-market equities and currencies enjoyed their best annual start in at least a decade this year through April. Then Brazil happened.

Developing-nation stocks, currencies and bonds were all hammered Thursday after O Globo newspaper reported on leaked testimony indicating that Brazil President Michel Temer approved payoffs to buy the silence of Eduardo Cunha, the mastermind behind last year’s ouster of former President Dilma Rousseff. Temer said he’s innocent. The MSCI EM Index of stocks had its worst day since November, as did a gauge of currencies. Crop prices collapsed because Brazil is a commodity powerhouse — the No. 1 exporter of sugar, soybeans, coffee and orange juice. The Bloomberg Agriculture Subindex posted its biggest intraday loss since August.

Emerging markets have always been a risky place to invest, but the drop in global volatility in recent months coupled with the relatively high interest rates in these places made them irresistible and easy for investors to ignore the dangers. “Let’s face it, EM was due for a correction,” Win Thin, Brown Brothers Harriman’s head of emerging markets, wrote in a research note. “Markets were pricing in perfection, and we just think there are way too many risks (both country-specific and globally) to warrant such rich valuations across so many markets. I don’t know yet how far this EM selloff can go, but my gut feeling is that it will not end soon.”

The selloff in U.S. stocks and the dollar abated Thursday, but that doesn’t mean there’s not plenty to be worried about. Many in the markets were focused on the shrinking in the yield curve. The gap between two- and 10-year Treasury notes yields has narrowed to 96 basis points, its slimmest margin since before the U.S. election in early November. While there always multiple reasons why the yield curve shrinks, it’s usually a sign that bond traders see slower growth and inflation ahead amid the political turmoil in Washington and as the Federal Reserve raises interest rates. That is corroborated by other bond market metrics. The breakeven rate on five-year notes, or what traders expect the rate of inflation to be over the life of the securities, narrowed to 1.70 percentage points this week, compared with about 2 percent as recently as early March. As a reminder, the Fed’s goal is to get the inflation rate to 2 percent, which the bond market is saying may not happen.  

The narrowing of the yield curve helps explain the weakness in bank stocks, which fell again Thursday even as the broader market stabilized. When you get down to it, banks basically make money by borrowing at low short-term rates and lending the proceeds out at higher long-term rates. So, when the difference shrinks, profits are pressured. The Bloomberg Americas Banks Index has now fallen 9.7 percent from its high this year on March 1, compared with a drop of just 1.26 percent for the S&P 500 Index. Losses on Thursday were tempered after Treasury Secretary Steven Mnuchin said breaking up the biggest banks would be a “huge mistake.” The remarks appear to put to rest a question that has been roiling the industry for months, according to Bloomberg News’ Robert Schmidt and Jesse Hamilton. Some Trump administration officials have suggested they were in favor of Congress passing an updated version of the Depression-era Glass-Steagall law that split commercial and investment banking, though they have been vague about what that actually meant.

The pound climbed above $1.30 for the first time since September after a report showed U.K. retail sales gained more than economists expected in April. Sterling appreciated against all of its 16 major peers after the report showed the volume of goods sold in stores and online rose 2.3 percent, more than twice the median increase forecast by economists in a Bloomberg survey, according to Bloomberg News’ John Ainger. The data pushed the currency through the psychologically important level that has acted as resistance in the rally since Prime Minister Theresa May called a snap election last month. The milestone marks the latest stage of recovery for the pound, which tumbled following Britain’s vote in June to leave the European Union. At its lowest point since the vote the currency was 20 percent weaker on June 23, a decline it has now trimmed to about 12 percent.

Speaking of yield curves, China’s anti-leverage campaign is causing a distortion that hasn’t happened in the nation’s $9 trillion bond market in at least a decade. The five-year sovereign yield is now higher than that on debt due in a decade, the first time the curve has inverted for those tenors in data going back to 2006, according to Bloomberg News’ Helen Sun, Jing Zhao and Emma Dai. The inversion illustrates the risk of China’s campaign to reduce leverage in the financial system, with higher borrowing costs influencing the corporate bond market and driving up rates for companies looking to refinance short-term debt. The nation’s nascent economic recovery is being pressured as well, with initial indicators including those on manufacturing suggesting that activity is slowing.

Fed data show U.S. banks may be regaining their appetite for making commercial and industrial loans following a pullback that some analysts attributed to uncertainty about how markets and the economy would react to Trump’s election. Every Friday afternoon the central bank releases a report on loans outstanding, and the last one showed the biggest two-week increase since March 2016, after a period of no growth between early November and late February and a big drop at the end of last quarter. Tomorrow’s data may not reflect the recent turmoil in Washington, given the time it takes for a loan to be offered and funds actually extended. JPMorgan Chief Executive Officer Jamie Dimon, who’s voiced support for many of Trump’s plans to stoke the economy, last month cautioned analysts not to overreact to slowing growth in commercial and industrial lending. Consumers and businesses are healthy, he said. “There will be ups and downs, wins and losses, stuff like that,” he said at the time. “But it is a pro-growth agenda.”

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Inflation Isn’t Cooperating With the Federal Reserve: Tim Duy

Saudis Seek Economic Boost From Trump Visit: John Sfakianakis

The Pump’s Already Primed So Hold the Tax Cuts: Noah Smith

Seeing a Debt Crisis That Isn’t Really There: Barry Ritholtz

It’s All Productive Enough for Government Work: Tyler Cowen

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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