What the bond markets are telling us

Bond investors are growing more worried about the short term. Here’s why that doesn’t bode well for the markets.

The market is a fickle mistress.

Sometimes people can see market panics coming in advance, like in 2008.

Sometimes the market drops all of a sudden leaving economists scratching their heads for decades, like the Black Monday stock market crash of 19th October 1987.

Financial crashes don’t necessarily let themselves be predicted by economic reason.

It’s an exercise in crowd psychology.

Markets crash when investors panic, regardless of whether economists think they have reason to be alarmed or not.

It doesn’t stop us from looking around us to see if the writing’s on the wall. This concerns our hard-earned money after all…

One of the indicators market watchers keep an eye on is the “yield curve” in bond markets.

The yield curve is the difference between what investors can earn from long-term government bonds compared to those that are held short-term.

Those margins are narrowing for UK gilts, US Treasuries, and European bonds. When that happens, analysts break into a sweat. Cassandras come running.

Are the bond markets trying to tell us something?

Something is up

When it comes to investments, government bonds are about the safest vehicle to put your money in.

It’s a safe haven investment, which means investors flee to the bond markets when they’re worried.

Bonds are reasonably safe because governments rarely ever go bankrupt.

When I talk about “safe” bonds, I’m referring to those issued by developed countries like the UK, US or Germany. Bonds from unstable economies like Venezuela are a lot riskier.

Bond markets are closely watched by those who read the economic tea leaves. Market watchers especially dread something called a “yield curve inversion”.

It’s not as complicated as it sounds.

Markets are about risk and reward. The riskier the investment, the higher the reward.

Bonds with a maturity of 10 years tend to pay more than bonds that need to be paid back in two years.

That’s because you hand over your money for a longer period. It’s harder to look a full decade into the future as opposed to two years.

A lot can happen in 10 years, while economic conditions are more likely to stay the same in just a few years’ time.

For this reason, investors get higher returns from 10-year gilts (UK government bonds) or 10-year Treasury notes (US government bonds) than when they purchase bonds with a duration of two years.

Makes sense?

Normally the longer you have to wait for your money back, the higher the yield.

We speak of a yield curve inversion when the yields of short-term bonds are getting higher compared to long-term bonds.

In other words, investors feel the short term is getting riskier than the long term. Clearly, something is up.

“For the UK in recent months, the gilt yield curve has flattened each time market there has been a rise in concern about a ‘no-deal’ Brexit or tensions between Brussels and London,” Abhinav Ramnarayan wrote for Reuters last month.

“Bond investors, it would seem, agree with the International Monetary Fund, the Bank of England and some of the world’s biggest banks and asset management firms that a ‘hard Brexit’ will damage the economy’s health.”

When bond investors start feeling queasy about short-term government loans, it’s time to pay attention…

Self-fulfilling prophecy

Investors aren’t just worried about the immediate future of the British economy.

The gap between 2-year and 10-year Treasury yields is at its lowest level since August 2007. The spreads between German short-term and long-term bonds have narrowed as well.

Especially for US Treasuries, an inverted yield curve is usually a harbinger of bad news.

Should you be worried?

Yes, you should be.

This yield curve acts as a warning sign. The last seven US recessions have been preceded by an inverted yield curve.

In the three times the UK gilt curve inverted in the past 20 years, the economy twice fell into recession and once underwent a sharp slowdown in growth.

Maybe it doesn’t say everything, but inverted yield curves generally don’t promise a lot of good. Paying no heed to this flashing indicator would therefore be unwise.

But: a car usually doesn’t stop working the moment a warning light starts flashing on the dashboard and it’s the same for these economic warning lights.

Economic growth can still remain strong for a while even as yield curves flatten.

And this warning light has proved less reliable for markets outside the US, for which it has over-predicted recessions.

Still, it’s not a good sign that bond investors in the UK, the US and Germany are all growing more anxious about the near future at the same time.

“It looks like the pressure is intensifying,” says Strategic Intelligence investment director David Stevenson.

“The looming yield curve inversion is now an incredibly powerful message that the economic omens – starting with the States but then spreading around the world – aren’t looking good at all.”

In any case, flattening yield curves seem to be proof that market sentiment is turning sour.

Perhaps it doesn’t even matter whether or not inverted yield curves can actually predict recessions.

If investors think they do, that fear will be reflected in the markets, at which point a recession becomes a self-fulfilling prophecy.

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