LONDON (Reuters) - If the bond market is to be believed, the world is heading for recession.
The turmoil sweeping through financial markets this year, principally driven by the plunge in oil prices and fears over China’s economy, has lowered government bond yields and flattened yield curves across the developed world.
The question is whether the “yield curve” retains its historical predictive power of indicating slowing growth or even recession in a world of zero - even negative - interest rates, negative yields and trillions of dollars of central bank stimulus coursing through the financial system, if not the real economy.
Longer-dated yields on a country’s bonds should normally be higher than short-dated ones because investors demand a higher rate of compensation for the increased credit and inflation risks they assume in lending over a longer timeframe.
This is a “positive” yield curve, “steepening” from left to right. But curves are flattening - short-term yields are anchored by expectations policy rates are going nowhere fast and falling growth and inflation expectations are depressing longer-term yields.
“It’s a little more complicated than it used to be. The shape of the yield curve today is very much a function of global central bank activity – negative rates and quantitative easing. This changes the mechanics of the yield curve with respect to pure growth and inflation signals,” said Lena Komileva, managing director at G+ Economics in London.
“But it does suggest a capitulation in investor confidence in the ability of central banks to reflate global growth or prevent another downturn. And that’s not a good confidence signal,” she said.
The U.S. two-year/10-year yield curve, the difference between two-year and 10-year borrowing costs, this week fell to 110 basis points, the flattest in eight years US2YT=RR US10YT=RR.
The 10-year yield fell below 1.90 percent and is down more than 40 basis points since the Federal Reserve’s historic interest rates “liftoff” in December.
A flattening yield curve has in the past been a reasonably accurate portent of slowing growth and an inverted curve, when the long-dated yield falls below the short-dated yield, an even more accurate guide to looming recession.
An inverted U.S. yield curve has preceded all five U.S. recessions since 1980, and an inverted UK curve preceded all three recessions in Britain since 1980.
On the other hand, a deep inversion of the UK curve for several years in the late 1990s-early 2000s did not herald recession, and Japan has endured four recessions since the mid-1990s without the curve inverting.
Global recession is loosely defined as growth below the roughly 2.5 percent needed for the world economy to keep up with an expanding population. Recession in a developed country is two consecutive quarters of economic contraction.
Several investment banks, including Citi, Bank of America Merrill Lynch and Morgan Stanley, have raised the likelihood of a U.S. or global recession in recent weeks.
Inflationary pressures and inflation expectations around the developed world are sinking thanks to low oil prices and the number of central banks that have eased policy since the start of last year continues to rise.
Euro zone inflation expectations as measured by the so-called five-year/five-year forwards, a gauge closely followed by the European Central bank, this week slid to within a whisker of a record low. EUIL5YF5Y=R
As government bond yields tumble the spread of corporate bond yields over the benchmark has widened, a worrying signal for some. Zak Summerscale, chief investment officer, European high yield, at asset management firm Babson Capital Management played down the widening but said it merited monitoring.
“The biggest risk is a significant recession. What really brings high yield crashing down on a fundamental basis is a significant recession, but we don’t see that at the moment,” he said.
Last week the Bank of Japan stunned markets by adopting negative interest rates on certain bank deposits, joining the ECB, Swiss and Swedish central banks in putting certain official rates below zero.
The market’s expectations of interest rate hikes this year from the U.S. and UK central banks have completely evaporated too. A rate cut in Britain is now more likely than a hike, according to current market pricing.
The Fed’s latest senior loan officers survey this week showed that lending standards to companies tightened for the second consecutive quarter in the three months to December, something that “has never happened before without signaling an eventual move into recession”, Deutsche Bank said on Thursday.
But with interest rate markets already heavily influenced by record central banks stimulus, some say the signals sent out by the yield curve are harder to read than ever.
Anton Heese, head of European rates strategy at Morgan Stanley in London, notes that absent central bank QE, or quantitative easing, yield curves would be steeper, traditionally associated with a strengthening economy.
“This is confounding for people who argue the yield curve is not giving its usual signal on the economy because of central bank action,” he said.
“The difficulty this time is we have an abnormal business cycle and more importantly an abnormal central bank cycle ... (although) one is always cautious about saying the current situation is different from previous periods in history.”
(Corrects Babson Capital’s Zak Summerscale’s view of the corporate bond market in paragraphs 17 and 18 that it is not signaling recession)
Reporting by Jamie McGeever and Dhara Ranasinghe; Graphics by Vincent Flasseur; Editing by Alison Williams