AS NAMES for market phenomena go, “inverted yield curve” lacks a certain punch. It is no “death cross” or “vomiting camel”. But what it lacks in panache, the inverted yield curve more than makes up for in predictive potency. Just before each of America’s most recent three recessions the yield curve for government bonds “inverted”, meaning that yields on long-term bonds fell below those on short-term bonds. Economists and stockmarkets seem unconcerned that inversion looms again (see chart). But despite generally strong economic data, there is reason to heed the warning signs flashing across bond markets.
There is nothing particularly magical about the yield curve’s predictive power. Short-term interest rates are overwhelmingly determined by changes in central banks’ overnight policy rates—for example, the federal funds rate in America, which has risen by 1.75 percentage points since December 2015. Long-term rates are less well-behaved. They reflect the average short-term rate over a bond’s lifetime, but also a “term premium”: an extra return for holding a longer-term security.
An inverted yield curve may mean a few things, none of them cheering. Markets may expect future short-term rates to be lower than present ones, presumably because the central bank has chosen to cut rates in response to economic weakness. Or markets may think they need less compensation for holding long-term bonds in the future. That might reflect expectations that inflation will fall, or that appetite will grow for the safety provided in financial storms by long-run government debt.
More generally, the yield curve often inverts when a central bank is expected to switch from a bout of monetary tightening to one of monetary easing. Such transitions often happen around the time a boom comes to an end and a recession begins. The flattening of the American yield curve over the past few years has occurred as the Fed has begun raising its main policy rate, in order to prevent a long expansion from becoming worryingly inflationary. Rate rises will eventually give way to rate cuts, most probably when Fed policymakers begin worrying more about slow growth than about inflation. At that point a recession might be on the cards. Inversion of the yield curve would warn as much.
The yield-curve omen is not simply folk wisdom. Research generally concludes that it is indeed a useful indicator of future economic conditions. An analysis by Menzie Chinn and Kavan Kucko, for example, in which the authors examined nine advanced economies between 1970 and 2009, determined that the spread between the yield on ten-year and three-month bonds was a meaningful predictor of industrial activity in the following year. According to a paper in 2008 by Glenn Rudebusch and John Williams (now the president of the Federal Reserve Bank of New York), simple predictive models based on the yield curve are better than professional forecasters at predicting recessions a few quarters ahead.
Yet there is also something strange about the enduring power of the yield-curve indicator. A reliable signal that a recession looms should prod central banks into preventive action. That should help avert recession, thereby destroying the predictive power of the indicator. It is possible that this is starting to happen. In their analysis Mr Chinn and Mr Kucko note that the relationship between the signal sent by the yield curve and subsequent growth was weaker in the 2000s than in previous decades. Perhaps central banks are wising up.
Or perhaps not. In 2006 Ben Bernanke, then the chairman of the Federal Reserve, expressed scepticism about the danger indicated by the yield curve, noting that he “would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come”. (It did.) When asked about the flattening yield curve in March of this year, Jerome Powell, the current chairman, echoed Mr Bernanke’s sentiment, saying: “I don’t think that recession probabilities are particularly high at the moment, any higher than they normally are.” Awkwardly, whether Mr Powell is right or not depends on how his Fed plans to react to the yield-curve signal.
Oh, inverted world
There are two potential reasons why the curve remains a portent. One is that central banks make mistakes. In 2006 Mr Bernanke argued that the yield curve’s signal was distorted by unusual purchases of American bonds by foreign central banks and pensions. Similar arguments are made today, concerning the effect of asset-purchase programmes by the European Central Bank and the Bank of Japan.
Yet just how much distortion is occurring is unclear, and the Fed could easily misjudge the friendliness of the global financial environment. Similarly, central bankers often overestimate the durability of a boom. Recessions happen when central banks overtighten. When such accidents occur, the yield curve inverts. Because the effects of monetary policy are felt only after some time, and because central bankers make mistakes, the yield curve retains its power.
The second reason to keep watching the yield curve is that central bankers generally worry more about high inflation than about rising unemployment. It is hawkishness rather than doveishness that leads to inverted yield curves and recessions, after all. The Fed’s own communications make this plain. According to its most recent projections, the policy rate will eventually settle at a level of 2.9%. But in 2019 and 2020 the policy rate will rise higher than that, meaning that cuts will be necessary later. The yield curve, the Fed is advertising, is quite likely to invert.
And why? Because, again according to the projections, the unemployment rate is now unsustainably low. A slowing of growth sufficient to bring the unemployment rate back up to what the Fed sees as its natural long-run level—4.5%, rather than the current 4%—is needed, lest inflation rise out of the Fed’s comfort zone. This strategy may well turn out to be a mistake. It will not have been an accident.
Japan still has great influence on global financial markets
IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.
“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.
This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.
One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).
But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.
Tokyo storm warning
These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.
Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.
What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.
Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.
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