US economy

Bonds are a better guide to the future than stocks


A ceasefire between the world’s two biggest economic powers is helping the US stock market end 2019 at record highs. This trade optimism has drowned out everything else. It marks quite a turnround since August, when the yield curve on US government debt inverted, sparking fears of a looming recession.

It would be negligent to dismiss that threat quite so easily. The bond market is better than the stock market at predicting economic downturns. Investors forget the summer’s warning at their peril.

Veteran investor John Templeton once dubbed “this time is different” as the four most expensive words in the English language. The first time I heard the costly phrase was in a finance lecture at university in the mid-1990s.

The dotcom bubble was growing, stock indices around the globe were surging to unprecedented heights, and the seemingly all-powerful Alan Greenspan was at the helm of the world’s most powerful central bank, the US Federal Reserve.

Our professor proclaimed an era of never-ending growth — a “new paradigm” in which globalisation and technological changes had consigned business cycles and inflation to history. We all know how that ended.

Four months ago, the bond markets sent a signal. Yields on 30-year US Treasuries, the “long” end of the curve, fell below those on the Fed’s overnight interest rate, at the “short” end.

This inversion has been a sure-fire indicator, historically, of an impending economic downturn. And yet American stock exchanges continue to climb to record highs on the back of positive trade news.

It is neither unprecedented nor unusual for share prices to continue to rise after a yield curve inversion. On the contrary, previous episodes have shown that this can go on for another 12 months. And it could be an additional six months on top of that before we see economic output begin to contract.

All precedents indicate, though, that both the stock market correction and the recession will both come eventually. Does anyone truly believe that this time will be different? Will a comprehensive trade agreement between the US and China be enough to avert what has so far been deemed unavoidable?

The unusual, almost contradictory, behaviour of the stock and bond markets we observed in November was puzzling. It was almost like an optical illusion, where what you see changes, if someone points out a different way of looking at it.

I was reminded of this when share prices went up following reports that a “phase one” US-China deal could be signed as early as mid-December while sovereign bond prices also rose, as yields declined. It seemed that fixed-income investors were paying more attention to US president Donald Trump’s comments that he was still prepared to substantially raise import duties if he did not get the deal he expected.

In an environment of increasing risk appetite, one would normally expect funds to flow from bonds into equities, not into both asset classes at the same time. Sovereign debt is supposed to be the haven into which investors flee in times of turmoil and uncertainty, not when investors are confident about the future. So, which of the two markets is right?

Historically, fixed-income investors have the better record: all prior yield curve inversions of the past six decades were invariably followed by a stock market downturn and a recession. But even the seemingly infallible bond market has not been immune to the vagaries of trade politics and presidential tweets of late.

Since the beginning of August, when pessimism about the trade conflict and the economy was at its worst, the US Treasury curve has steepened once again, and the inversion seemed almost forgotten.

But periodic sell-offs, following threats of retaliatory tariffs against other US trading partners and bad headlines on the US-China deal, highlight the fragility of a rally entirely driven by political news and promises.

In his best-selling book The Black Swan, Nassim Nicholas Taleb argues that our human need to make sense of past events — especially the traumatic ones — compels us to invent a narrative that lets the course of events appear congruous, even unavoidable. However, while things unfold, we allow ourselves to claim no inclination of the end result.

It is hard to tell what the narrative will be in 12 months’ time. My hope is that it will not be: “I told you not to dismiss that yield curve inversion so carelessly.” But I cannot shake that uncomfortable hunch.

The writer is executive director for applied research at financial analytics company Qontigo



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