Longer term government bond yields are lower than short term bond yields and cash rates in many economies including in the United States and Australia. Inverted yield curves tend to be harbingers of recession, because they occur when investors in financial assets are so concerned about future economic prospects that they need a safe-haven at any cost. The cost is forgoing the risk premium usually required to consider investing long-term as opposed to short-term.
The same fears that produce this unusual investment behavior among investors in financial assets also influence the behavior of households and businesses in the real economy. Essentially, households and businesses become more cautious preferring to try and save more rather than spend more. The paradox is that what might be considered prudent behavior, saving more to provide a buffer for more difficult times ahead, contributes to delivering more difficult times as the economy weakens from insufficient spending.
There are good reasons why investors in financial markets are surveying the far horizon through their binoculars and think they have caught sight of a recession. The economic recovery in the US is long in the tooth (the longest in at least 160 years) and for US businesses is showing signs of age in terms of constrained earnings margins and peaking profits. The trade war between the US and China is disruptive too lifting prices of inputs for some US businesses and constraining export opportunities and perhaps more importantly the unpredictability of the erratic announcements about the trade war from President Trump add to uncertainty about the future dampening business investment spending.
Outside the US, China’s economic growth rate looks set to slide further in Q3 based on mostly disappointing July readings of industrial production and retail spending. Apart from China’s economic growth prospects, the stand-off with Hong Kong’s swelling numbers of democracy protesters is another source of uncertainty about the future.
Returning to economic indicators, monthly export readings continue to weaken through most of Asia. In Europe, GDP growth is modest and the disruption from Brexit still looms in late October with no sign that the recent change of Prime Minister has improved the likelihood of negotiated British exit from EU. The one place where recession hunters could be vindicated in the near-term is Britain where seriously debilitating uncertainty would instantly occur in late October if Britain leaves the EU without any arrangements covering the movement of money, goods and people between Britain and its biggest market, the EU.
Yet for all of these factors that might conceivably lead to recession there are also several indications, especially in the US, that recession is a long way off – too far away for bond investors to go on a successful hunting expedition.
In the US, the economy continues to grow and at over 2% annualised pace in Q2 despite the increasing problems facing some US businesses. Household spending is by far the biggest part of US economic growth and it continues to grow strongly assisted by low unemployment, strong employment growth and wages rising at the fastest pace in a decade. Unsurprisingly (except perhaps to bond investors) retail sales in the US are rising fast, up a much greater-than-expected 0.7% m-o-m in July. Very low long-term US bond yields are also helping to pull lower long-term home mortgage interest rates in the US firing up home buying activity. The main leading indicators of housing activity in the US are pushing higher in July and August.
With strong growth in US household spending activity virtually assured in Q3, and highly likely in Q4, US recession hunting becomes an increasingly risky business particularly for those investors holding long-term bonds at very low or no yield where even small upward movements in yields translate to big capital losses.
A run of US economic data highlighting the improbability of recession in the near-term is not the only thing that bond market recession hunters need to fear. Any announcement of a large fiscal expansion in one or more of the bigger economies could cause longer-term government bond yields to head higher.
If the authorities in China perceive a threat of too-low economic growth they are likely to expand budget spending substantially. Elsewhere, the virtue of trying to balance government budgets and reduce government debt becomes questionable when there is a potential problem of households and businesses saving too much driving down long-term interest rates, especially interest rates on government debt. The case is starting to build that governments should fill the deficiency in private sector spending and borrow more and spend more, especially on infrastructure adding to the productive resources of the economy.
Governments have it in their power to spend more, reduce recession risk and pay minimal interest on the additional debt incurred. It seems only a matter of time before the Government of a big economy overcomes queasiness about adding to government debt, takes maximum advantage of very low bond yields and in turn lights the fuse on higher bond yields and higher global growth prospects.
Bond market recession hunters beware. The hunt for recession and the associated very low bond yields may soon lead to circumstances where bond yields rise and the recession hunters become the hunted.