Inverted yield curves may have had their day

For the first time since the Great Financial Crash of 2008 it is cheaper for the UK and US governments to borrow over the longer term – say ten years from now – than in the short term.

In the jargon, what we are seeing in global bond markets is known as an inverted yield curve: this is when long term bond yields are lower than short term ones.

And the reason that global markets are so spooked is that traditionally, an inverted yield curve foreshadows a recession. This is because it implies that growth in the future will be lower than it is today.

Indeed, each time the yield curve has inverted in the US, there has been a recession soon afterwards. In the US this week, the yield on 30-year Treasuries fell below 2% while the 10-Treasury yield dropped below that of the two-year bond for the first time since June 2007. According to Bloomberg, the world’s negative-yield debt has now grown to more than $16 trillion.

There was a similar fall in UK bond yields with 5-year gilts offering lower yields than 2-year gilts, indicating it is cheaper for the UK government to borrow for five years rather than for two. In Germany, which saw a contraction in growth over the second quarter of the year, the yield gap between 10-year and 2-year German government bonds is also trading at its tightest since the crash.

The omens are not looking good. Fears of a new recession intensified by President Trump’s ridiculous turf war with China and China’s own skirmish in Hong Kong were enough to send equity markets in a tail spin around the world.
The Volatility Index, known as VIX or the so-called fear index run by the Chicago Board Options Exchange, was on the move again while gold spot prices are also on the rise.

What these indicators are suggesting is that investors around the world are willing to earn lower returns on their investments by holding them for longer, the reverse of the norm as usually investors want higher returns for investing over the long term because of unforeseen risks.

Now that situation has been turned on its head. The starkest impact of this scenario is that banks can’t make money out of borrowing short-term and lending long-term. We can already see the result: in Denmark, Jyske Bank, the country’s third largest, has begun offering borrowers a 10-year deal at minus 0.5%, while another Danish bank, Nordea, is to offer 20-year fixed-rate deals at 0% and a 30-year mortgage at 0.5%. Jyske said borrowers will make a monthly repayment as usual – but the amount still outstanding will be reduced each month by more than the borrower has paid.

Good news for new home owners but a sure sign of nerves about where the financial markets are heading. Negative interest rates mean that a bank is paying a borrower to take money from them and will pay back less than they are loaned. That’s a preferable strategy to the risk of borrowers taking out higher interest loans that they won’t be able to pay back in the future.

Jyske is able to make this mortgage possible as Denmark has seen rates in the money markets fall to such low levels that it can borrow from institutional investors at negative rates. Its a similar situation in Sweden and Switzerland.
What does Jyske Bank’s foray into negative interest rate territory mean ? Some say that it foreshadows a recession but it might also be part of a wider change in the evolution of finance and banking more generally. But that’s for another time.

For now, the question is whether the latest inverted yield curves suggest the world is heading for another recession.

Not everyone thinks so as today’s world of negative interest rates and years of QE makes for a distorted one.  Andrew Neil, the broadcaster and journalist, was one of the first to take a contrarian view. In a tweet, Neil asked: “But I wonder if in a world of QE and negative interest rates, the inverted curve means as much as it used to. Perhaps only if we think it does.” Perfectly put.

Andrew McNally, chief executive of Equitable Investments and author of Debtonator, agrees with Neil that the yield curve is now a bad predictor of recessions. If, indeed, it ever was a good one.

McNally points out that most people think of the yield curve as the difference between 10 year and 3 month Treasury yields. “But on that simple measure the Fed’s own models thinks an inversion implies the risk of recession within the next 12 months at just over 30% – hardly a compelling forecast. And the whole yield curve is not one way right now.”

He also believes that the Federal Reserve’s approach over the last few years is now affecting expectations to the point that the yield curve is distorted, and so even less useful as a predictor of growth.

For the reality is that the US economy is in good shape, as today’s consumer data showed. Consumer debt is at reasonable levels and interest rates look as though they will be coming down further.

Adding fire to the latest bonfire is President Trump’s own war with Jay Powell, head of the Federal Reserve, over interest rate policy. He is already trying to pin the blame for this latest market turmoil by hitting out at Powell, calling him “clueless,” and saying it is the Fed’s fault for having raised interest rates four times last year rather than cutting them as he wanted.

As Trump tweeted: “the Federal Reserve acted far too quickly, and now is very, very late” in cutting borrowing costs… “Too bad, so much to gain on the upside!”

In many ways Trump is right: the US fundamentals are good and the economy will keep growing, as it always does.

But the President’s rudeness doesn’t help. Nor do his war of words with China or indeed, Europe.

Yet Trump may have won his battle, with the Fed at least. Powell has said he will do what it takes to mitigate the impact of any trade war, suggesting lower rates.

Bond pundit, Mohamed El-Erian, chief economic adviser at Allianz, also reckons US rates will come down further, even though such cuts are not justified on economic grounds. As El-Erian puts it: “ The Fed will have no choice but to reduce rates. The markets are holding them hostage right now… The cuts will be made for negative reasons, not positive ones. The Fed is afraid of the market’s reaction if it doesn’t act.”

There is another factor playing the devil with the markets: it’s August. Wait till everyone is back from the beach and had time to cool down before stashing away the cash or piling into gold.