Bond market trading points to a US recession within two years, souring sentiment on global share markets. (Reuters: Simon Dawson)
There’s an old saying: “Bonds never lie”.
- Yield curve inversions are seen as solid predictors of recessions over the next one to two years
- Equity markets often enjoy a last gasp rally after a bond inversion, but on average fall 30pc once recession bites
- Rising trade tensions, crumbling manufacturing data, low inflation and weaker US profits are key drivers of the collapse of short term bond yields below the 10-year rate
Right now the US bond market is staring investors straight in the eye and saying, “there’s a recession on the way”.
When the yield on 10-year US government bonds finally slipped below 2-year yields overnight, the penny dropped on equity markets. Actually, it was a bit more than that; closer to $US770 billion ($1.2 trillion) on the S&P500 alone.
The ASX chipped in with a $40 billion loss straight after.
Normally long-term bonds pay a much higher yield than short-term bonds, reflecting risks and uncertainties off into the future.
The yield inversion is saying the risk has arrived. It may not be on the doorstep yet, but it has pulled up and is unbuckling its seatbelt. Cue threatening music in a dramatic key.
“The equity market is on borrowed time after the yield curve inverts,” is the message from Bank of America-Merrill Lynch (BoAML) strategists in New York.
While there are all sorts of maturities in bond markets (the three-month and 10-year spread had already inverted), the spread between the two-year and 10-year yields is particularly pertinent given that two years is the shortest-dated US Treasury note, and the most sensitive to rate movements.
For that reason, it is the spread that is most widely cited as an accurate indicator of impending recession.
Here are some relevant facts about bond inversion which the BoAML team dug out in its research.
- Yield curve inversions preceded the last seven recessions
- The average and median lengths of time from inversion to the start of a recession are 15.1 and 16.3 months
- The S&P500 can take time to peak after a yield curve inversion
- During US recessions, the average S&P500 drop is 31.7 per cent over 15 months
Yep, that’s right. On average, the US share market drops around a third of its value.
The BoAML team didn’t put the ASX through its model, but you can draw your own conclusions.
The relatively good news is that recessionary impacts during established bull markets are less severe than those during established bear markets, averaging a 20 per cent slide as opposed to 40 per cent market capitulation.
Yield curve inversions have preceded the past seven US recessions (Source: Refinitiv Datastream)
Last gasp rally on the cards
While bond markets have become increasingly agitated, equities have remained relatively relaxed — until last night, at least.
That shift in sentiment doesn’t mean equities are about to tumble into an immediate death spiral.
The BoAML team says history suggests a “last gasp” rally is likely.
“Sometimes the S&P500 peaks within two to three months of a 2s10s inversion but it can take one to two years for an S&P 500 peak after an inversion,” they note.
So why has it happened?
Basically, US bond investors have a far gloomier view of the world at the moment than either equity investors or the US Federal Reserve.
The obvious catalyst has been the increasing hostility between the US and China on trade, and tensions between protesters on the streets of Hong Kong and the Chinese government.
“In the past, yield curve inversions usually occur when the short end of the curve [2-year bond yields] — which proxies monetary policy rate expectations — rises above the long end [10-year bond yields],” BNY Mellon’s John Velis said.
“This time around, the long end has fallen more than the short end has risen.
“Even in economies like Germany, which have endured extraordinarily low yields for some time, growth and inflation expectations have worsened, leading yields even lower at the long end of the curve,” Mr Velis explained.
Worsening global economic data — including a manufacturing recession in Europe — and inflation showing little interest in climbing off the mat, coupled with the belief central banks are running out of tricks to stimulate international growth again has rattled investors.
While a full-blown trade war may be enough to trigger a global recession and send the ageing bull market to the abattoir, it is not the only worry.
US corporate profits are not that great, and arguably not strong enough to sustain some pretty lofty expectations on equity markets.
In a recent note, Morgan Stanley’s global head of economics, Chetan Ahya, said the global economy was on the skids.
“If the US were to implement 25 per cent tariffs on all imports from China for four to six months and China responds with countermeasures, the global economy will likely enter into a recession in three quarters’ time,” he said.
US corporate weakness
But that’s not the end of the worry beads.
“Small and mid-cap companies are seeing an earnings growth problem — their first quarter year-over-year earnings growth fell by double digits,” Morgan Stanley told its clients overnight.
“Small and medium-sized businesses, where the majority of the US labour force works, are slowing their hiring. Manufacturing is the bellwether for the economy and tends to lead the jobs cycle.”
As corporate savings get depleted, margins and profits come under pressure, and the whole thing can unravel rather quickly. It also makes investing directly in US companies less attractive, squeezing even more capital into bond markets.
“The first cut is hours worked as companies cut hours of current staff before laying people off. This is starting to show up in the data even if we haven’t seen jobless claims pick up yet,” Mr Ahya said.
“We also expect lower sentiment and soft spending in the month of August, as market volatility tends to go hand in hand with soft consumer spending.”
In other words, things are likely to get much worse before they get better.
Buckle up, it could get nasty.