Recession bugs are all over this one. The yield curve—essentially the difference between long- and short-term interest rates—is a time-tested predictor of economic downturns. And to many, it is now screaming that at least a global slowdown is in the works. Yet other reliable leading indicators, like copper and stock market indexes, have been off their game in recent years. Is the yield curve also just blowing smoke, or is its predictive power still intact?
First we need to consider how we got to this point. Softer economic performance has spurred an about-face at the Federal Reserve Board (Fed), and global central bank talk, particularly at the Jackson Hole conference, has shifted to monetary easing. Although Chairman Jerome Powell and other prominent central bankers maintain that this is not an easing cycle, markets are expecting more rate cuts and easing measures. This has thrown stock markets into a volatile zone, and sparked a bond market rally. Numbers showing Germany and the United Kingdom dangerously close to recession, together with speculation that the global loss of momentum will continue is sustaining the bond rally, weakening long-term rates and solidifying the yield curve inversion.
Second, it’s important to understand the speed and the magnitude of the change. Until a few weeks ago, the Fed was in tightening mode, and economic concerns were still weighted toward tight labour markets, constrained productive capacity and the likelihood of near-term inflation. The United States and Canada were raising interest rates, and the European Central Bank (ECB) was a definite wannabe. Bond prices were swooning, and there was a wholesale repricing of risk affecting both developed and emerging markets. One can only imagine the extent to which large global wealth portfolios were adapting to this sea change in events.
Portfolio managers are now having to cope with the second policy U-turn in relatively short order. Volatile equity markets and shrinking bond yields are making their lives difficult, to say the least. Under pressure to maximize their total yields, they face the awkward dilemma of having to invest in higher-risk, higher-return assets at the same time as the deteriorating global business climate is pushing those high risks higher. Major funds could be facing an inexorable rise in portfolio risk.
They face another problem: an increasing segment of securities is in the negative-yield zone, primarily in Western Europe. Why? Well, at the short end, yields were pretty close to zero to begin with, so curve inversion means negative long yields. Portfolio managers either won’t or can’t invest in this stuff. And it’s not small change; it currently amounts to US$ 16 trillion.
Given this, the amount of instruments available for large fund managers is notionally lower, forcing them into a reduced market. For low-risk plays, the U.S. market is the logical first stop, and for some may well be the only stop. As such, portfolio rebalancing is likely putting significant downward pressure on U.S. yields, quite in spite of the fundamental strength of the U.S. economy. In short, conditions are making it difficult for the U.S. to resist the trend.
Current momentum alone suggests that things will only deteriorate from here. Is that what we should prepare for? Not necessarily. Let’s remember where this all started: economic weakening was the trigger point. But that weakening was caused not by soft economic fundamentals, but by global trade friction and the tariffs and brinksmanship that followed. Fix the turmoil, and things should get back to where they were: the relief that follows resolution leads to an unleashing of on-hold investments, spurring higher-than-expected growth. Central bankers could then in good time be back to a rate-tightening regime. It might sound fanciful, but remember: they were there just a few months ago.
The bottom line?
Economic precariousness has spilled into financial markets. If liquidity is compromised, it could weaken wealth funds, and easily exacerbate the current slowdown. One further compelling reason to resolve today’s international trade impasses.
