To give due credit to prognosis of the bond markets, it is important to note that US yield curve over the several decades has inverted on most of the occasions ahead of a US recession.
There has been an unprecedented dash for safe-haven assets given the widespread global concern of growing protectionism, low inflation and slowing economic growth. The recent developments in global bond markets foretell a risk of recession, with the US spread between the widely watched its 10-year and 2-year sovereign bonds inverting briefly, while the spread between three-month bill rates and 10-year yields has been inverted since May this year. Needless to mention, the increasing market value of negative yielding bonds, which has soared to $16.5 trillion, quite a humongous number in a $56 trillion global bond market. Literally, 50 percent of the sovereign bonds are now fetching sub-zero yields. Interestingly, the entire German yield curve is under water.
With investors flocking to inflated bonds, fetching deep negative yields, the situation begets an important debate whether the rally in sovereign bond prices has gone too ahead of itself. Although there is evident slowdown in global economic activity, an outright risk of recession has not yet materialized. There a growing rhetoric regarding an impending slowdown in US, but the fact remains that private consumption remains resilient in the world’s largest economy. Most importantly, governments in Europe and Asia are gearing for unleashing fiscal stimulus, which can counter the deceleration seen in manufacturing and trade. A likely fiscal stimulus across the global can provide the much-needed impetus to the global economic engine, which can eventually foster uptick in inflation and unwinding of the long only bond trade.
The moot point remains whether such a degree of buoyancy is justified in the bond markets. Though the global economy has slowed down, there is no outright risk of a global recession materializing yet. The IMF sees the global GDP expanding 3.2 percent in 2019 and then growth rebounding to 3.5 percent next year. Despite the yield curve inverting in US, consumer spending (which is the lynchpin of economy) remains strong. Indisputably, growth across the globe is slowing down, but the situation is not tantamount to a recession. To wit, the estimated dividend on global equities is much better than average bond yields in the developed world. Estimates state that that dividend yield on the global stock benchmark is expected to rise to 2.5-2.75 percent this year. The astonishing fact remains that German bond yields are much negative than Japanese despite relatively higher inflation in Germany.
Nations on the brink of bankruptcy enjoying ultra-low yields
An extraordinary rise in global sovereign debt across the world has coerced yields to the proximity of 0 percent even in nations which were on the verge of turning bankrupt seven years ago. With the preponderance of negative yields in Europe, investors are scrambling for marginally positive yields even in riskier debt markets of Spain and Portugal. This seems to be nothing short of a bubble. Expectations of further quantitative easing by ECB is also driving sovereign yields of peripheral economies like Greece lower which had to undergo debt crisis and financial rescue packages from EU.
Fiscal Stimulus will be an inflection point
There is an argument that whether recession fears are overblown. Governments across the world acknowledge that Central Banks have exhausted their arsenal in terms of driving inflation and growth through interest rates. With interest rates running well below the historical trends and balance sheets being bloated, there is very less scope for the central banks to step on the gas. There is a growing sense that governments will turn on the fiscal faucet to provide the much needed impetus to the economic engine.
Coordinated fiscal stimulus by the major economies is expected to counter the deceleration in global economic growth. US President Trump is running from post to post for the infrastructure spending bill, while Germany, South Korea and Australia are contemplating at loosening their purse strings. It is imperative for economies with twin surplus (budgetary and trade) to make their fiscal policies more accommodative. The fact that Central Banks have been pre-dominant owners of sovereign debt makes it much easier for the government for fiscal expansion. In fact, Eurozone economies also have the luxury of borrowing at negative real interest rates. In Asia, Beijing has already stepped on the pedal by allowing provincial governments to borrow more through the issuance of bonds to fund infrastructure projects.
Shortcoming of Yield Curve
To give due credit to the prognosis of bond markets, it is important to note that US yield curve over the several decades has inverted on most of the occasions ahead of a US recession. However, there can be distortions in the bond markets, where long term rates are artificially suppressed below the short-term bonds. As a case in point, US Federal Reserve’s quantitative easing in 2011-2012 entailed selling of short-term Treasury bills and buying the long-term instruments. This was done to augment credit creation within the economy by lowering the long-term interest rates.
The other criticism to the yield curve is that it cannot accurately predict when the recession will set in. There have been wide variations in the historical data, which shows that the US10-2yr yield curve has inverted several quarters (ranging from 3 quarters to 2 years) before the economic contraction takes place. So, the moot point remains that if the US10-2yr yield curve inverts again, nobody has the clairvoyance on when the US economy ventures into recession. The so called impending recession can remain elusive for several quarters or even a year or two.
In this respect, Bloomberg Recession probability indicator convey only 1/3rd probability of a US recession in next 12 months.
Free Money Syndrome
There is a reinforced new belief within the global financial markets that low interest rates should remain as low as possible to stimulate growth in future. Loss of faith in the existing financial system has given birth to the Free Money Syndrome. In fact, inflow of capital is channelized into firms which are burning cash. If this is not enough, a Danish bank is offering home loan at a negative interest rate, implying people get paid to borrow. The sense that individual borrowers benefit from ultracheap or negative rates is fallacious given that such gratification in the form of free money impairs the banking system. It also kills the saver in the economic system, depriving his/her ability to earn interest on existing money over time. The wider question remains how the banks can turn profitable by losing interest income. This is a flawed allocation of capital into loss-making and often disruptive enterprises, eventually resulting into lower financial returns.
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