About a decade ago you could pick up virtually any newspaper (with perhaps the exception of the Daily Star or the Sun) and see the phrase Double Dip Recession or equivalent brandished on the front page. Whether it was accompanied by a vitriolic attack on the incumbent Conservative government, a backward-looking blame on Gordon Brown’s Labour Party or a picture of a Panda from Edinburgh Zoo depended on your choice of paper… but regardless, we spoke about recessions day after day. Markets cared too, the Pound suffered an awful time losing about half of its value against the Euro and the Dollar during the latter half of that decade partially on recession concerns. The risk of that happening again deepened yesterday.
If you chose a financial news bearer this morning, then you would have been hit in the face by headlines of bond yield inversion and fixed income market chaos. Others went directly for the link to recession suggesting one is now on the cards not only in the UK but in Germany and the United States of America. So, what happened? Well investors yesterday for the first time since 2007 (the starting and focal point of the Great Recession) demanded a lower yield for loaning money backed by the full weight of the respective nation’s government over a 10-year time horizon than over a 2-year duration. Let me explain briefly why you should care:
If someone said to you that you can have £1000 or $1000 in two years’ time or in ten years’ time, I think you’d decide to have it in two. I shan’t make assumptions on your choice of currency given the looming threat of parity! In fact, given almost any time differential I’m convinced you’d rather have the money sooner – you don’t have to take the risk of receiving it any longer than necessary and you can start to do stuff with that money – no brainier! Well, that’s no longer the case today for bond market investors. The reason why market players take this deal despite it seeming like an idiotic idea is because they trust the central bank’s rate to determine the so-called ‘front end’ of the curve – the one most affected by incumbent monetary policy.
So, take the US, investors won’t accept less than a 2% yield to loan money to their government because they could just go to their central bank, the Federal Reserve, and pick that up immediately with truly almost zero risk. But over a ten-year horizon, the promise of 2% today starts to fade. Markets have now priced the value of a 10-year duration bond higher than the 2-year contract (meaning that it confers a lower yield) suggesting that they believe economic activity and growth will grind to a standstill over those years. There’s certain value in market players’ opinions but I’ll be the first to admit it’s limited. The really worrying part is that this inversion witnessed yesterday can be a self-fulfilled prophesy; markets could have made a recession a foregone conclusion.
Every recession in the US and UK, in the 1980s; 90s; 2000s, has been preceded by domestic yield curve inversion. The signal they sent yesterday will firstly cause fear in the short run and the immediate sell off in equities yesterday confirms a withdrawal of investment and a preference for low risk. So, if people stop spending you’ve delivered yourself a recession, job done. On top of that, and secondly, if it’s cheaper to borrow money for a longer period of time than over two years you’re far less likely to consume now and instead put it off for cheaper long term money, again, delivering you towards an imminent recession.
In response to yesterday’s action emerging markets have sold off severely. The Rand in particular has taken a battering and trades cheaply this morning. The Euro and Pound failed to pick up any defensive demand particularly because the move yesterday was spurred by negative German quarterly growth data and, on Sterling’s side, due to the risk of Brexit and Westminster’s turmoil. The Dollar admittedly enjoyed limited relief but the simultaneous threat of recession on that side of the Atlantic limited the greenback’s advance. The Yen was one of the only serious winners yesterday given its status as an ultimate safehaven. Volatility ticked up with the VIX, a popular market traded instrument measuring volatility and risk, topped the important 20 level. Timing becomes even more important in these conditions and our desk is on hand to guide you through yesterday’s shakeup and the path forward.
Discussion and Analysis by Charles Porter