Markets yield to fears of a global downturn
The nearest thing the global economy has to a doomsday clock ticked a little closer to midnight this week, triggering fear across financial markets. On Wednesday, the US yield curve — the slope formed by the interest rate paid by Treasury bonds of various maturities — turned upside down for the first time since the summer of 2007, with the US government now paying less to borrow for 10 years than two years.
Although seemingly obscure, the yield curve enjoys a cult following among investors as the leading market forecaster of recessions. Normally, countries should pay less to borrow money for shorter time periods. When this relationship flips it has historically been an omen of economic downturns — presaging every US recession since the second world war.
This week’s inversion rattled global stock markets even though the move was widely forecast, extending the FTSE All-World index’s decline in August to over 4 per cent as investors fret that the countdown to the next recession may now have begun.
“The yield curve is one of the best signals out there,” says Robert Michele, chief investment officer at JPMorgan Asset Management. “Its accuracy is eerie.”
The yield curve is essentially a reflection of the distilled wisdom of millions of investors, from individual savers, financial advisers and small Midwest banks to Middle East sovereign wealth funds, Asian insurers, European pensions and Wall Street money managers. If the economic outlook dims they tend to look for safety and buy government debt, pushing up their price and crimping their yields. But when long-term yields fall below short-term ones — which are more closely linked to the interest rates set by central banks — it indicates that investors foresee a downturn and imminent interest rate cuts.
President Donald Trump weighed in, blaming the Federal Reserve’s slowness in lowering interest rates for the “CRAZY INVERTED YIELD CURVE!”. Former Fed chair Janet Yellen downplayed the inversion, predicting that the US economy would avoid a recession, but conceding that “the odds have clearly risen and they’re higher than I’m frankly comfortable with”.
The yield curve’s ability to forecast recessions is hotly debated, but the inversion indisputably reflects the bond market’s mounting fears over a global economic slowdown. The IMF last month trimmed its forecasts for global growth to 3.2 per cent for 2019 — which would be the lowest in a decade.
Some economists think even this is too optimistic. Trade tensions between the US and China, the world’s two economic superpowers, have been ratcheted higher since the IMF’s latest forecasts. The German economy, the European powerhouse, has contracted, adding to the market alarm.
The most eye-catching manifestation of the anxiety is bonds trading with negative yields, with many countries — and even some companies — in practice now paid by creditors to borrow. The phenomenon picked up speed over the summer as expectations have risen that central banks will have to aggressively ease monetary policy.
Many investors predict that this move would prevent a slowdown from becoming a recession, and argue that panic over the yield curve is overwrought.
Nonetheless, a sense of gloom is spreading across markets, with few signs that the trade war will disappear any time soon. The longer the tensions linger, the bigger the toll on the global economy, and if they deepen then all bets are off, investors warn.
“We think it’s a manageable conflict,” says Bob Browne, chief investment officer at Northern Trust. “But if it becomes unmanageable and we have a full trade war, then that’s a risk that even the Fed can’t avert.”
The world’s central bankers meet next week on the outskirts of Jackson Hole, a rural town in Wyoming, for the annual monetary policy extravaganza thrown by the Federal Reserve’s Kansas branch. The scenic location, first selected to appeal to former Fed chair Paul Volcker’s love of fly-fishing, has become one of the premier venues for a select group of policymakers, academics and investors to discuss the biggest economic issues. The slowdown and ways to address it will be prominent for those attending this year’s symposium.
Nearly $16tn worth of bonds are now trading with sub-zero yields, or about 27 per cent of the global total, according to Deutsche Bank. Negative interest rates in Japan and Europe, coupled with the central banking bond-buying splurge, are big contributors to the odd trend of creditors paying borrowers. But the growing fear over the global economic outlook is also a big factor, analysts say, with investors willing to pay for the security of safer debt.
“No one has a playbook for negative rates,” Mr Michele says. “It’s uncharted territory, and that’s what makes central banks so uneasy.”
The US Treasury market has thus far remained untouched by the phenomenon. But with the Federal Reserve cutting interest rates last month and expectations of more aggressive cuts to come, even the once unthinkable — negative yielding US government debt — has become at least feasible.
“There is international arbitrage going on in the bond market that is helping drive long-term Treasury yields lower,” former Fed chair Alan Greenspan said this week. “There is no barrier for US Treasury yields going below zero. Zero has no meaning, beside being a certain level.”
There is still some way to go before US government bond yields dip into negative territory. But this week’s yield curve inversion both reflects and exacerbates the current bout of nervousness surrounding the economic outlook.
There are many ways to measure the shape of the yield curve, such as comparing 30-year Treasuries to five-year ones, or 10-year yields to three-month Treasury bills — another popular measure that turned upside-down earlier this year. But the two-year, 10-year yield curve inversion that happened this week is particularly popular as an economic omen among many investors.
“Although other measures of the US yield curve have progressively inverted over the last few quarters, [the] 2s-10s inversion is the one that worries me most,” says Jim Reid, a senior strategist at Deutsche Bank. “It has the best track record for predicting an upcoming recession over more cycles than any of the others.”
Adding to the pessimism, on Thursday, the 30-year Treasury yield went below 2 per cent for the first time ever, after China accused the US of “a severe violation” of their previous trade agreement, and said that it “will have to take the necessary countermeasures”.
Many investors argue the gloom is overdone. The global economy is slowing, and trade wars are a major risk, but aside from the bond market’s amber warning light there are few concrete signs that a recession is looming.
That is especially true in the US, where jobs are still being created at a healthy clip and American household spending — arguably the single-biggest engine of the global economy — remains robust. Data released on Thursday indicated that industrial production contracted in July, but retail sales were much stronger than expected.
“People are extrapolating from weakness in manufacturing to services and consumption, and I just don’t buy it,” says Rick Rieder, global chief investment officer of fixed income at BlackRock.
Some analysts say the yield curve’s predictive powers are overstated or malfunctioning, because of the sheer amount of post-crisis bond-buying by central banks and pension funds. The Fed argues that it may be artificially depressing long-term bond yields and making the curve a less accurate harbinger of recession.
Moreover, the shape of the curve has been a poorer predictor of recessions outside of the US. Even there, the span of time between inversions and recessions has become progressively longer over the years. The post-second world war average lag between inversion and recession is about five quarters, but the curve inverted nearly two years ahead of the 2008 financial crisis.
Ashish Shah, co-chief investment officer for fixed income at Goldman Sachs Asset Management, says equity markets are far from pricing in a potential recession, despite the jitters. He argues that sagging bond yields are more reflective of the muted inflation outlook and expectations that central banks will once again do whatever it takes to buttress the global economy.
“The bond market’s takeaway is that if growth slows then central banks will act preemptively,” Mr Ashish says. “And if it doesn’t then they won’t act aggressively to raise rates.”
For central bankers at Jackson Hole — and investors — the question they may have to confront is whether the global economy’s monetary superpowers have the ability to forestall any future recession, having already used up much of their firepower.
European Central Bank president Mario Draghi seems determined to launch one last big stimulus before he leaves the institution in October. But eurozone interest rates are already negative and the ECB is butting up against limits on how much government debt it can buy. Other central banks have also floored the monetary pedal, and while the Fed has some room to trim rates, it may not have enough to counteract a trade war-triggered global downturn.
“I don’t think there is in aggregate enough central bank firepower left,” Mr Michele says. “If it wasn’t for the trade war we might have a chance of averting a recession, but at this stage all we can do is try to ease it.”