One of Wall Street’s enduring lessons, “inverted yield curves don’t always predict recessions, but all recessions have inverted yield curves”, is back in the headlines as yields on 10- and 30-year US treasuries go berserk at levels not seen since 2007 and investors grudgingly price in “higher for longer” rates – the kiss of death to their preferred goldilocks soft-landing scenario.
Yet it’s not just the high level of yields that is worrying pundits but also the pace at which they are rising, which seems unwarranted given recent US economic data and the Fed’s hawkish policy. Hence the suggestion that interest rates are not the only reason for surging yields and the runaway US fiscal deficit is playing a big part as well. Why do you think nothing — not even worries about the economy, geopolitical concerns, even a last-minute deal to avoid a shutdown — has been able to trigger a bond buying spree?
That explains why Edward Yardeni, the famous Wall Street economist who coined the term “bond vigilantes” in the 1980s and has been warning of their return throughout their hibernation in the low interest rate environment since the 1990s, especially the quant easing era following the 2008 great crash, has his “I told you so” smirk plastered all over the financial press these days.
Now the president and chief investment strategist of his own firm Yardeni Research Inc, he first used the term in 1983 to describe unhappy investors who dumped bonds to force a revision of monetary and fiscal policies by driving up yields.
“Usually supply and demand don’t really matter that much because federal deficits tend to widen during recessions when the Fed is lowering interest rates,” he told Bloomberg TV in August, when yield on the 30-year bond reached its highest level since 2011.
“This time we have federal deficits widening when the economy is doing well. I think the bond vigilantes are quite concerned about that. There’s way too much supply”.
Just a month-and-a-half down the road, with the federal budget deficit escalating and bond supply outstripping demand, higher yields are naturally required to “clear the market”. Weaker than expected data, especially real personal consumption expenditures and consumer sentiment, should have driven yields lower, yet they continue to rise because investors demand more compensation for long term risk.
But despite the interest rate trauma at the long end, the yield curve remains inverted. Economists and analysts tend to use different segments of the curve to indicate an inversion in rates. Some prefer the 10- and 2-year treasuries, others like 5- and 10-year notes. But the Fed pays more attention to the 10-year and 3-month spread because there have been times when longer-dated maturities inverted but this one did not, and a recession was avoided.
Historically, recessions have begun 12-18 months after an inversion, a long enough window for the usual “this time will be different” argument that the media is overflowing with once again. Also, recessions begin when the inversion ends and the spread returns to positive territory.
This time the spread traded much wider than previous inversions, mainly because of excessive liquidity pumped into the market during the Covid pandemic. Yet now, at -0.96 percent (at the time of writing), it is racing back to the zero line. And since it dipped into red towards the end of last year, around Oct-Nov, the traditional 12-18 month window for recession seems wide open.
Milton Friedman’s seminal work that won him the Nobel prize in economics postulated that monetary policy “operates with long and variable lags”. It’s now been 18 months since the Fed started raising interest rates, another ominous sign that coincides with the treasury spread recession timeline.
It seems bond vigilantes have risen from the dead to haunt the US economy in the thick of the most hawkish monetary squeeze since the Volker Fed of the 80s, just when the financial colossi of Asia and Europe are also on their knees.
China’s property nightmare has gutted its shadow banking system, threatening contagion across the region, and Germany’s credit crunch and sluggish economy – barely 0.2pc above pre-pandemic levels – has earned it the title “the new sick man of Europe” from economists.
Things are not much better in emerging markets, where far too many countries, including Pakistan, have sovereign debts trading at default levels. Contrary to the all-is-well claims that help hedge fund managers and central bankers sleep better, the cold logic of the market dictates betting on yet another global recession.
Copyright Business Recorder, 2023
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