We’ve heard a great deal in the past few days over yield curve inversions and how they are often harbingers of upcoming recessions.
It is certainly true that they have been good leading indicators of impending economic slowdown in the past, however they have also given off false signals as well.
There certainly appears to be a significant dislocation in what US bond markets are telling us and what the US economy is telling us, when it comes to the economic data.
Throw in concerns about US, China trade, slowing growth, the risk of recession in Europe, particularly Germany, Brexit, the possibility of Italian elections, unrest in Hong Kong, as well as a crisis in Argentina, and tensions in the Arabian Gulf and its perhaps not surprising that investors are moving into areas which generate a positive rate of return.
Over the last week or so we’ve seen the amount of negative yielding debt rise from $14trn to $16trn as well as observe gold prices hit record highs against the Japanese yen, Swiss franc, euro and the pound.
The only reason that we haven’t seen gold hit record highs against the US dollar is probably more to do with the fact that US yields are still firmly in positive territory.
This more than anything helps explain why we’ve seen US and UK bond yields move sharply to the downside in the past week or so, with the US 30 year yield falling to a record low below 2%, along with expectations that the US Federal Reserve may look to start cutting rates more aggressively in the weeks and months ahead, and possibly as soon as next month.
The only hole in this particular argument is that the US economy isn’t, at the moment, really showing any signs of needing another rate cut. The latest retail sales numbers shows the US consumer in rude health, and with unemployment near multi year lows and wages rising at a decent clip it’s hard to make a case for a big rate cut at this point in time.
Bond markets, on the other hand, have a tendency to be more forward looking, but even allowing for that unless the US economy undergoes a sharp collapse it is hard to see how the Fed can play catch up with what bond markets are currently pricing in, by year end.
Inflation remains subdued, with China pushing out a significantly deflationary wave out through the global economy, if recent PPI data is any guide. This time last year factory gate prices in China were at 4.6%, and since then have come down hard, slipping into a 0.3% contraction last month.
That is a significant fall, and combined with the slide in the yuan has had a magnifying effect.
This downward pressure on prices makes it difficult to see where the next bout of inflation could come from, especially if there is no speedy resolution to the geopolitical headwinds that are buffeting the global economy and markets.
As such the question facing investors is whether the inversions we are seeing is because of the risks of an approaching recession, or because interest rates are so low, and in a lot of cases negative, that investors are not only looking for any yield anywhere they can find it, or looking to price out recession risk, as well as some deflation risk as well.
I think it’s probably a case of all three, and in the context of historical precedents it’s also important to remember that financial conditions and money velocity are significantly different to the last time we saw inversions in the yield curve.
Interest rates for one are at record lows levels, so it’s difficult to argue that historical precedents apply, when rates were well over 5%.
When interest rates are already at record low levels and yield curves are so flat, inversions tend to be a direct consequence of the flatness of the curve. As such cause doesn’t always lead to effect.
That being said while as an analyst I’m always minded to look back and take the view that history repeats itself, I’m always minded to think of something that Mark Twain is reputed to have said “History doesn’t repeat itself, but it often rhymes”.
In other words take nothing for granted, and only trade what you see.
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