The global decline in long dated yields and the inversion in the US government bond yield curve are worrying signs but not all-out alarms.
With more than a quarter of global bonds trading on a negative yield and many government benchmarks at record low levels, the negativity on negative yields adds to the growing recession watch chorus.
But what do bond yields really tell us about the health of the economy?
Buying a government bond means lending the government money. There are a variety of factors which determine the compensation or interest the lender earns – general levels of supply and demand for the bonds, the prevailing cash rate at the time, length of the loan, and expectations around how much economic growth therefore what the level of inflation will be in the future.
All else equal, a longer maturity bond, higher cash rate or higher expected inflation should all add up to a higher yield on government bonds. So in an environment where the longer dated bonds command a higher yield than shorter dated ones, the expectation is that there will be more growth and inflation in the future than there is currently. Stated a different way, a steep yield curve is positive for the growth outlook.
Today however, the yield curve is either very flat or negative in many economies around the world, depending on how you measure it. This suggests little is being priced in by investors for future growth or inflation over the coming decade. It also means investors are willing to hold safe assets such as government bonds even with very low expected returns – indicating risk aversion.
Historically, the yield curve has been a reliable indicator of recession. Seven of the last nine times that the spread between the US 10-year and two-year became negative, a recession followed. It wasn’t immediate and took on average 14 months for the recession to begin after the yield curve inverted.
What’s worth noting is that in all seven of those instances, the US Federal Reserve was hiking interest rates. This is not a coincidence.
As the economic cycle progresses, resources become scarcer, spare capacity diminishes and the economy starts to run “hot” as inflation pressures build. Naturally the central bank responds to higher inflation by increasing interest rates to cool things down and meet inflation targets.
Rising interest rates lift the yield on shorter duration bonds, while lowering the yield on longer dated bonds as expectations for future growth and inflation fall. Put another way, monetary policy dictates the shorter end of the curve and economic conditions impact the longer dated part of the yield curve.
Eventually the combination of tighter monetary policy and downgrading of the economic outlook inverts the yield curve as markets price for a recession.
We shouldn’t ignore that this historically reliable indicator of the economy is telling us a recession may be looming. But markets have changed significantly in the last decade and yield curve inversion is not the harbinger it once was.
Negative yields and flattening yield curves reflect not only risk-off markets but they are symptoms of unorthodox monetary policy since 2008 and are signals that these ultra-accommodative policies may be reinvigorated imminently.
The European Central Bank and Bank of Japan already have negative deposit rates which are likely to delve further into negative territory in response to sluggish economic activity. At the same time, the restarting of bond buying programmes will create downward pressure on long dated bond yields.
Yield curve inversion is flashing a warning sign – investors should check their portfolios are resilient. But it’s not a reason to panic or to lean into the sell-off. Certainly, bonds have already rallied a lot already this year and are getting more expensive, but they remain an important part of portfolios. And the market corrections can also offer fresh opportunities to pick up equities at more reasonable valuations.
Kerry Craig is a global market strategist at J.P. Morgan Asset Management.