Let’s face it: Bonds are boring. Usually, stock markets are the source of hyperventilation and headlines.
But right now, all the action is in the bond market. It is sending powerful signals that there’s economic trouble ahead for the United States economy. They’re powerful enough, in fact, that they’re even rattling the parts of Wall Street that people do talk about.
Does it mean a recession is imminent? Certainly not. Part of what makes the bond market so ominous is that it’s not terribly specific. But there is good information buried in the weeds.
Here’s what to make of it.
Yields Are Falling Everywhere
When investors get nervous, they buy government bonds. Why? Governments (usually) pay back their debts, so those bonds are a safe bet.
Those purchases push prices higher. And when bond prices rise, the yields — or the fixed interest rates investors collect on their bond investments — fall.
So, falling yields are to the economy what barometric pressure is to the weather: When they drop it’s often a sign that some kind of storm is coming.
And lately, they’ve been falling fast. Everywhere. In Japan, Britain, Australia, Germany and the United States. Long-term yields on government bonds around the world are hitting some of their lowest levels in recent years.
The Inverted Yield Curve
This tumble in long-term bond yields is especially unnerving because it has pushed long-term yields even lower than short-term yields.
In an economically rational world, investors would demand higher interest rates on long-term bonds than they do for short-term ones. The reason: Locking up their money for a longer period is usually riskier and investors get paid more for that risk.
Today, in the United States, a government bond that’s due in three months will pay a higher rate than a government bond that is due in 10 years.
These occurrences, called inversions, are rare, and they have grabbed Wall Street’s attention for one simple reason: They have preceded every recession over the last 60 years (although some of those downturns took up to two years to materialize).
Inflation Expectations Are Dropping
One of the biggest boogeymen for investors in long-term bonds is inflation. Rising prices would gradually eat away at the buying power of a fixed investment in those bonds.
But nobody in the bond market seems to be thinking about inflation. In fact, bond investors’ expectations for inflation over the next five years has fallen this month, and that should worry anyone who is looking to predict the state of the global economy.
It suggests that litany of economic headwinds — the trade war, Brexit, slowdowns in Europe and China — is having an effect on growth.
The bond market’s reading on inflation is most obviously evident in the yields on what are called Treasury inflation-protected securities, or TIPS.
TIPS are essentially a kind of Treasury bond that is periodically adjusted to account for inflation. The difference between yields on these adjusted bonds and standard Treasury bonds, is often used as a ballpark estimate for inflation expectations among bond market investors.
Lately, the difference between those yields has been shrinking fast, falling to about 1.60 percentage points in recent days, a clear sign that the bond market sees no inflation ahead.
Investors Are Betting on a Cut
Foremost among those who worry about the economy and inflation are the people at the United States Federal Reserve. In recent weeks, officials from the central bank have spotlighted the persistent weakness of inflation as a reason for concern, though they’ve stopped short of saying more rate cuts are coming down the pipeline.
Since the Fed made an abrupt about-face on raising interest rates, investors have been slowly increasing the odds they put on the Fed actually starting to cut rates.
And according to the bond market, those cuts are almost a done deal.
You can see this in the shape of the yield curve, a shorthand way of referring to string of different yields on the range of bonds offered by the United States Treasury, from short-term bills to the longest maturity security the United States government sells, the 30-year bond.
As we said before, in a typical bond market universe, investors insist on higher interest rates on longer term bonds. And until relatively recently, that’s how things looked.
About a year ago, this is what the yield curve looked like:
Since then, the yield curve has been warped by growing expectations that the Fed would cut interest rates sometime over the next couple years.
Here is what it looks like now. That dip is how we know investors expect a rate cut.
Rate cuts can be manna from heaven for the stock market. If the bond market is so sure they are on the way, shouldn’t the stock market be soaring?
Well, if the Fed cuts interest rates, it would probably be doing so for a good reason. And that reason could only be that the risk of recession is real.
Investors typically don’t rush to embrace risky stocks if they think a recessionary wave is threatening to overtake the economy, even if interest rates are coming down.
Hold on. Sure, maybe the global economy is having some trouble. But the United States seems fine.
After all, growth in the first quarter was at a surprisingly strong 3.2 percent annual rate in the United States. At 3.6 percent, American unemployment has hit its lowest point since 1969. Corporate profits are high. Wages are rising.
All true. But around the world, and in the United States, investors in the bond market are behaving as if something strange is afoot.
Given their track record on calling turning points in the economy, it would be unwise to ignore them.