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 (US time), the US yield curve – the yield formed by the interest rate paid by various 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 is one of the leading forecasters of recessions. Normally, countries should pay less to borrow money for short 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 to all-world indexes in August to over 4 percent as investors were counting down to the next recession.

"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 advisors and small mid-sized 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 debt and push their prices and crimping their yields.

But when long-term yields fall below the short-term ones – which are more closely linked to the interest rates set by central banks – it indicates that investors anticipate 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!" Fed chair Janet Yellen downplayed the inversion, predicting that the US economy would avoid a recession, but conceded 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 reversal 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 this is too optimistic. Trade tensions between the US and China, the world's two economic superpowers, have been ratcheted up by 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 with the trading of negative rates, with many countries – and even some companies – in practice now paid by creditors to borrow. The problem is that they will have a greater impact on the financial situation.

Many investors predict that this move would slow down to become recession, and argue that the yield curve is overwrought.

Nonetheless, a sense of gloom is spreading across markets, with few signs that the trade will disappear any time soon. The lingering tensions, the bigger the global economy, and if they are deepen then all 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 not warn."

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. Paul Volcker's love of fly-fishing is one of the first comings 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 US $ 16 trillion worth of bonds are now trading with sub-zero yields, or about 27 percent 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 trend of creditors paying borrowers. But the growth fear is a big factor, analysts say, with investors willing to pay for the security of safer debt.

"No one has a playbook for negative rates," Michele says. "It's uncharted territory, and that's what makes central banks so uneasy."

The US Treasury market has thus remained untouched by the phenomenon. But with the Federal Reserve cuts down on prices, even the unthinkable ounce – 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," Fed Chair said Alan Greenspan said this week. "Zero has no meaning, being at a certain level."

There is still some way to go before. But this week's yield curve inversion both effects and exacerbates the current end 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 this year. But the two-year, 10-year yield curve that this week is particularly popular as an economic omen among many investors.

"Although other measures of the US yield curve have been progressively [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 percent 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 down, and trade is a major risk, but it is a sign of a recession is looming.

That's 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 do not buy it," says Rick Rieder, global chief investment officer of fixed income at BlackRock.

Some analysts say the yield curve is 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 less accurate harbinger of recession.

Moreover, the shape of the curve has been a poor predictor of recessions outside the US. Even there, the span of time between inversions and recessions has become progressively longer over the years. The post-second world war is lagging behind the recession, 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 the markets are in a potential recession, despite the jitters. He argues that sagging bond yields are more reflective of the inflation outlook and expectations that will central banks will once again do whatever it takes to the global economy.

"The bond market is so strong that it will grow preemptively," Ashish says. "And if it does not then they will not act aggressively to raise rates."

For central bankers at Jackson Hole – and investors – the question is one of the world's most important economic 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 the limits of debt.

Other central banks have also floored the monetary pedal, and while the Fed has some room to trim rates, it may not be enough to counteract a global trade-triggered downturn.

"I do not think there is enough in central bank firepower left," Michele says. "If it was not for the war we might have a chance of waring a recession, but at this stage we are trying to ease it."

Written by: Robin Wigglesworth

© Financial Times