Something strange has been happening in the bond markets. It has happened before, in 2007 for example and in the year 2000. In both cases, recession in the US and across much of the world followed. Are we set to see a repeat?
Do flattening yield curves warn of impending recession?
Alan Greenspan called it a conundrum, during the latter period of his time as chair at the US Federal Reserve, the so-called yield curve flattened, meaning that the gap between the yield on long-term bonds and short-term bonds was falling. In the past, such an occurrence often turned out to be an early warning of a recession. But in 2005, when the phenomenon re-emerged, the US and global economy were booming and very few economists thought there was any likelihood of a recession.
Then in late 2006, when Ben Bernanke was running the show at the Fed, the yield curve went negative. We all know what happened next. It took a year or so, but against most expectations, not only did the global economy enter recession, we saw the worst financial crisis in 80 years.
Is it happening again? The US yield curve has hit its narrowest level since 2007. As I write, the yield on ten-year US government bonds is 2.8620 per cent, and on two years it is 2.5242 per cent. Actually, the gap has widened in the last 24 hours, but the underlying point is that the yield curve is currently fluctuating at around a level that is at an 11-year low.
Look beyond the US, to the big wide world, and things appear to look worse. The global yield curve is already negative and for the first time since 2007. There may be a technical reason for this, a higher proportion of UK, German and Japanese government debt has a more distant maturity date. The average maturity timeframe for UK government debt is 12-years, for US debt it is 6.4-years. And since rates are lower in the UK, Germany and Japan, than in the US, the effect is to push down the average yield on longer term bonds, worldwide.
Even so, the numbers are clear, in both the US and across the global economy, the yield curve is the flattest it has been since the eve of the financial crisis.
In the US, two forces are at work influencing the risk of recession. For one thing, you have the massive Trump fiscal stimulus – tax cuts without a corresponding cut in government spending – at a time when US unemployment is at its lowest level in 17-years. It seems that the US government is stimulating the economy when there is very little spare capacity.
Number two: there is the risk of a trade war. This all boils down to whether we see escalation, whether the Trump rhetoric becomes reality, and whether the rest of the world - Europe, Canada, Mexico, China, Japan and India in particular, respond in kind.
I have some curiosities for you.
- The US trade defect has been improving for a while.
- Net immigration to the US from Mexico has been negative for some time. (Yes, negative, and while Obama was the President.)
- The US tax cuts largely benefit the richer people in the US, who tend to have a higher savings ratio, consequently the impact on the US economy may not be so great.
- Despite what you might read elsewhere, private sector debt across much of the world - with a few exceptions - is lower now than in 2008.
Looking at some of the above facts, it is tempting to conclude that certain policy makers have been looking at the trend, and then made it their policy to create the very thing that is happening anyway. Mr Trump could rein back in his trade war and anti-Mexican rhetoric and yet, in a couple of years claim victory so his supporters can say his savvy negotiating style was the cause.
If that above explanation is right, the US may pull back from the brink of a trade war, and recession before the next US election will be avoided.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees