David Chance: ‘Bond market inversion is early red flag for recession’

Saturday Insight

It is time to start worrying about the global economy, and it is not economists crying wolf this time, it is the bond market sending an urgent signal that has not been seen since 2007 when the global financial crisis hit.

The U.S. Treasury market, the biggest and most liquid in the world which is a benchmark and safe haven for investors, saw the yield curve between bonds with a three-month maturity and those with a ten-year maturity invert.

James Carville
James Carville

In layman’s terms that means that the 3-month paper pays a higher interest rate than 10-year bonds, a reversal of the normal state of affairs when investors are compensated for the risks of lending for longer.

When Treasuries start to signal worries in the US economy, we in Ireland have to pay attention as growth here is much more leveraged to the American cycle than it is to the European economy or even to the British economy thanks to the huge investments by the tech and pharmaceuticals companies here, according to research by top NTMA economist David Purdue.

The move in markets came yesterday as traders digested a change of policy from the Federal Reserve which they interpreted as signalling the central bank was more worried about the chances of a downturn in the global economy than previously and the yield on the 3-month paper was one basis point (1/100th of a percentage) more than that on the longer paper.

Although the Fed kept its interest rates unchanged at its policy-making meeting in Washington this week, cuts to its economic outlook saw the world’s leading central bank move from a stance where it had planned two possible rate hikes this year to one where it saw none.

That in turn dragged down stock markets and other financial markets and concerns are growing that with the last financial crisis barely over, we are now headed for a recession and that there are few remedies available as the central banks who saved the world from 2008 on have run out of ammunition and ideas.

To be sure, the 3-month-10-year spread is not the benchmark, but it is an important signal.

The measure that would really set the market hawks loose would be an inversion in the 2-year/10-year spread which is currently a positive 10 basis points.

Every time that there has been recession since World War II, this has turned negative and with economic indicators turning negative and growth forecasts across the world dropping sharply, a sense of foreboding has started to grow among central bankers.

“Not only will they have less policy space compared to previous economic downturns, but they face all sorts of political pressures which – in the extreme – could seriously dilute their independence,” said Dario Perkins, Managing Director of Global Macroeconomics at leading London-based economic consultancy TS Lombard.


“Officials know the next recession will require a large fiscal response and the only question is how subservient central banks become as part of this transition.”

Central banks shouldered most of the burden of boosting the world economy in the last financial crisis and at the peak the Bank of Japan, Federal Reserve, European Central Bank, Bank of England and Sweden’s Riksbank held $15.3 trillion of government bonds, equivalent to around a third of all the government debt of those countries.

While there is no doubt that swift and coordinated action by central banks did a lot, there are concerns that continued low rates and the prospect of even more negative interest rates acts as a disincentive to invest because it makes companies and individuals more worried about the economy.

Just look at Irish households whose deposits with banks exceed loans by €13bn, a signal perhaps that many people are still scarred by the financial crisis and are unwilling to take on new debt for fear of a repeat.

The latest economic data from the eurozone on Friday made grim reading and implied just 0.2pc economic growth for the bloc.

If Brexit was the top worry keeping you awake at night, it is probably time to lose even more sleep over the bond market. It is time to recall the words of James Carville, who ran the campaign that got Bill Clinton into the White House.

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

Irish Independent


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