The bond market is flashing a recession warning, but that’s no cause for alarm yet
- Historically, a yield curve inversion precedes a recession. However, following an era of easy money, an inversion might simply signal that markets are expecting loose monetary policy again
Out driving the other day, an orange warning light appeared on the dashboard. My first thought was not that the engine was about to burst into flames, nor did I abruptly pull over. I continued driving towards where I was going and then I drove home again.
My calmness was due to the realisation that warning lights themselves are not a sign that something bad has happened – smoke from the engine would be in this case – but that something bad may happen.
More than a quarter of global bonds have negative yields, the yield on German government bonds has recently turned negative all the way out to 30 years, and many other government benchmarks are at record-low levels.
All the negativity on yields adds to the growing chorus of global recession-watchers. But what are bond markets really telling us about the health of the economy?
Buying a government bond means lending the government money. There are a variety of factors which determine the compensation or interest the lender earns, general levels of supply and demand for the bonds, the prevailing cash rate at the time, the length of the loan, and expectations around how much economic growth, and therefore inflation, there will be in the future.
Bond market’s warning signal does not mean recession will follow
All else being equal, a longer-maturity bond, higher cash rate or higher than expected inflation should add up to a higher yield on government bonds. So, in an environment where longer-dated bonds command a higher yield than shorter-dated ones, the expectation is that there will be more growth and inflation in the future than there is now. To put it another way, a steep yield curve is positive for the growth outlook.
Historically, the yield curve has been a reliable indicator of recession. In seven of the last nine times that the spread between the US 10-year and 2-year notes became negative, a recession followed. It wasn’t immediate and took on average 14 months to begin after the yield curve inverted.
As the economic cycle progresses, resources become scarcer, spare capacity diminishes and the economy starts to run hot as inflation pressures build. Naturally, the central bank responds to higher inflation by increasing interest rates to cool things down and meet inflation targets.
Here’s why you can’t trust market signals any more
Rising interest rates lift the yield on shorter-duration bonds, while lowering the yield on longer-dated bonds as expectations for future growth and inflation fall. Effectively, monetary policy dictates the shorter end of the curve and economic conditions affect the longer-dated part of the yield curve.
Eventually, the combination of monetary policy tightening and downgrading of the economic outlook inverts the yield curve as markets price for a recession.
The yield curve inversion is a flashing warning sign– investors should check that their portfolios are resilient. But it’s not a reason to panic or to lean into the sell-off. Certainly, bonds have already rallied a lot this year and are getting more expensive, but they remain an important part of portfolios. And the market corrections can also offer fresh opportunities to pick up equities at more reasonable valuations.
Kerry Craig is a global market strategist at JP Morgan Asset Management