Recessionary Warnings On, and Fed’s Jackson Ahead

Global bond markets have been flashing recessionary warnings, and central banks have listened.
Andria Pichidi

Global bond markets have been flashing recessionary warnings, and central banks have listened. The Fed cut rates for the first time in over a decade in July, and the ECB is poised to bring out its bazooka again in September; the PBoC has been actively intervening, while several other central banks have surprised with easings of their own in recent months

The focus this week will be keenly on the FOMC minutes to the July 30-31 meeting and the Jackson Hole Symposium. Both have yielded policy hints in the past and the markets will look for any such nuances to current outlooks, including the extent of worries over downside risks from trade uncertainties.

The big underlying questions that will remain unanswered for now, however, are not only whether the US can avert a recession, but whether it can help lift the world out of a contraction.

The markets’ fears over recession were heightened after the Treasury yield curve inverted since the idea behind the use of a yield curve is to measure investors’ perception of risk and future developments in the bond market, as well as the overall economy.

What is a yield Curve?

Theoretically, the yield curve’s tilt presents investors with perspective as to how the economy will deploy, in simple terms, bond investors’ feelings about risk. The yield curve is considered to be the most closely watched predictor of a potential recession. As such, in a healthy economy, the yield on shorter-term bonds, which expresses the return investors are getting for committing their funds, is expected to be lower than the yield on longer-term bonds.

As we stated last October,

“The idea is that short-term bonds carry lower yields because lending to someone, regardless of whether that person is the government or the average Joe, is less risky for the investor; the longer you commit funds, the more you should be rewarded for that commitment, or rewarded for the risk you take that the borrower may not pay you back. This behavior is referred to as the normal yield curve, and reflects economic expansion as investors show how confident they are about the economy by their level of demand for government bonds.”

At the point in which the short-term bonds offer higher yields than longer-term bonds, we have an “inverted” yield curve. This is widely regarded as a bad sign for the economy and a recessionary signal from the bond market. The lower the yields due to the low interest rates, the slower the economic growth.

What about last week’s yield curve inversion?

Last week, the indicator yelped even louder as on Thursday the 30-year Treasury bond made a new historic closing low at 1.974%. The 2s-10s spread was seen in negative territory only briefly for the first time since 2007. Even though it never did close below zero, markets’ fears over recession were heightened after seeing this inversion.

In general, the reason behind the inversion of the yield curve, is that in times of great uncertainty like last week but in general the whole of 2019, investors become nervous, and turn to less risky assets such as Treasurys, which are among the world’s safest investments. The higher the demand for bonds will be, the lower the yields.  As seen last week, the weak data from China, the contraction in the German economy during Q2, ongoing Brexit uncertainty, and the optimism generated by an apparent thawing in US-China relations ran head on into fresh concerns that a recession is on the way.

What to expect from now onwards?

As geopolitics remain major headwinds, Brexit is approaching the October 31 deadline fast, the protests in Hong Kong, political instability in Italy, disarray in Argentina and monetary easing from an array of countries, are seen dampening the global blow, investors’ anxiety is expected to extend further in the long term.

Hence the main theme of the upcoming months is likely to remain on the recession and trade concerns. Even though the inverted yield curve might be a signal of the start of a recession, if a recession comes, firstly it will take a while, and secondly it is expected to be a global recession, with the US economy less impacted than the rest of the world, as the US retail sales and labor market is holding up well. On the other hand, the rest of the global economies, and especially China, might suffer a severe fallout, not only due to the trade war and geopolitical tension but also due to its productivity slowdown due to its shift from export-oriented manufacturing to domestic real estate and infrastructure, the reduced working-age population etc.

Nevertheless, this week, optimism persists as investors are already pricing out some of the recession fears that hit confidence earlier in the month amid growing conviction of decisive stimulus measures, with the FOMC and ECB on very supportive footing.

Ahead of the Jackson Hole Symposium, hopes are high that the central bankers might take further steps to support economic growth if needed. The upcoming US-China trade talks and the Treasury’s announcement that it is looking into issuing 50- or 100-year bonds are also a source of cautious optimism, in the near term. A global risk-on rally lifted equities and yields, as optimism from late last week spilled over into the new week. This picture is expected to hold during the week.

Andria Pichidi, Market Analyst at HotForex

(Read Our HotForex Review)

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