In a climate where recessionary terror rages across the globe, Economics Nobel laureate Robert Schiller offered a glimmer of rationality through his deft remark that while yield inversion may not signal a recession, public panic will! It’s all in the mind after all.
Yields on 30-year US bonds recently crashed below 2% and those on UK 30-year gilt bonds slipped under 1% for the first time. Both yields are lower than those on respective short-term bonds. Neither are yields rising in Germany, Australia, Japan, and Singapore.
Now, Yield Inversion of US Treasury securities i.e. long-term bond yields falling below that on short-term bonds, is a more reliable indicator of an oncoming slowdown. By no means is this 100% accurate or the only signal – in the same week the S&P 500 gained 0.3% and the Dow Jones Industrial Average 0.4% even as Nasdaq Composite lost 0.1%.
Recession is negative economic growth for two successive quarters. While Germany (-0.1%), UK (-0.2%), and Singapore (-3.3%) have hit negative growth in Q2-2019, the US economy clocked 2.1% growth. U.S. unemployment rate in July 2019 stood at 3.7%, close to the 49-year low.
Sounds confusing – positive developments on one front, negative on another.
Yield Inversion & Recessionary Fears
Bond prices move in a direction opposite of bond yields and policy interest rates. This is because:
During economic booms, bond prices fall while bond yields and interest rates rise: Investors expect greater returns during boom times. Only bonds with low prices and high yields attract investors who are more tempted to riskier but more lucrative investment options such as stocks.
But then, booms usually cause inflation, which policy makers counter by hiking interest rates – elevated rates lower money supply and make borrowing costlier. Holding long-term bonds (maturity: over 10 years) is riskier than holding short-term bonds (maturity: 1-3 years) because inflation poses greater threat over the longer duration.
Therefore, yield on long-term bonds is more affected by interest rate changes vis-a-vis yield on short-term bonds.
During economic slumps, bond prices rise while bond yields and interest rates fall: Investors flock to bonds during slowdowns. Remember, they are fixed-income securities and, therefore, safer. Spiking demand for bonds means investors are okay with higher bond prices and lower yields.
Policy makers cut interest rates to make borrowing cheaper and expand money supply. The expectation is, entrepreneurs will borrow for business and people will spend more as money is cheaply available. In turn, this is supposed to create demand for goods and services, stimulate production, and facilitate economic recovery.
And since long-term bond yields are more exposed to interest rates, they decline faster than those on short-term bonds. Precisely, this is yield inversion and its relation with economic bad weather.
But the connection is precarious at best. U.S. stock indices gained in the same week of yield inversion. Plus, unemployment is low. The Indian economy presents another confusing picture. Yields on 10-year bonds climbed to 6.6%, but unemployment is at a record 8.2% as auto, steel, and IT companies slow down and/or cut jobs.
Sentiment & Other Indicators
At the root of all economic events is sentiment – how people and particularly market players perceive the situation. Sentiment is often the deciding factor. If certain measures and events inspire confidence, markets climb up. Else, they fall.
Optimism makes people spend and invest, thereby creating demand for the production of goods and services, which stimulates businesses. Pessimism does the reverse.
Here is an exhaustive list of other indicators:
- Stock Market: is the first economic indicator that people look to. Rising markets inspire optimism and vice versa. But markets are manipulation-prone and surge temporarily after fiscal and monetary stimulus as people expect growth.
- Gold-Silver Prices: usually move opposite to dollar movements because people regard them as dollar alternatives. When markets tank, gold-silver usually shoot up as people invest in them. Learn more about gold’s investment prowess during market pessimism in our article: Decoding the Rise, Rise, and Rise of Gold.
Spiraling Gold Prices Since end-May 2019
Image Courtesy of ICE Benchmark Administration, London Metal Exchange, Shanghai Gold Exchange, World Gold Council
- Private Debt: rising private debt (100-150% of GDP) means businesses spend more on repayment and less on productive investment. Private debt caused the 2007 U.S. mortgage crisis, 1997 Asian financial collapse, and 1991 Japan slowdown.
- Economic Growth: positive growth is desirable. But, GDP improves momentarily with fiscal and monetary stimulus as people think positively.
- Unemployment: a 3-5% unemployment rate is healthy. Anything more and people become pessimistic.
- Income Levels & Corporate Profits: increase when the economy is fine. Not always though – profits were high before the 2008 crash.
- Production-Consumption Scenario: increased manufacturing activity in combination with rising retail sales and heightened inventory levels is optimistic and vice versa. Upswing in just one of these three does not automatically suggest optimism.
- Inflation & Interest Rates: both normally escalate and decline respectively during booms and busts.
- Construction Operations & Housing Prices: vigorous building activity and climbing house prices hint economic optimism and vice versa. Remember how housing prices plunged in 2006 before the subprime mortgage crisis.
- Trade Deficit: excessive deficits can escalate domestic and foreign debt, and devalue currency.
- Currency Value: robust currency allows greater imports and attracts foreign investments, but doesn’t help exporters. Falling currency makes public and investors pessimistic.
Zeitgeist is German for “spirit of the times.” Manipulations apart, it is the people who define zeitgeist. As is amply clear from the discussion on indicators, what finally matters is: how people feel – optimistic or pessimistic.
Management gurus will tell you, people are the most important element of any business operation. Markets are no different. Behavioural economics and behavioural finance say that people’s feelings matter big in market developments. How – zeitgeist!