If global markets are unsettled, they have good reason to be so

Every year the Federal Reserve Bank of Kansas City hosts a symposium in the Grand Teton resort of Jackson Hole. Some years, guests have little to do but chew the fat and listen to distinguished speakers explain points of economic importance. Sometimes, though, the conclave in Wyoming takes place with a crisis looming. One such year was 2008. This year is shaping up to be another.

Global financial markets certainly fear the worst. Share prices slumped last week amid fears that the first recession since the big crash of 2008-09 is just around the corner. The trigger was developments in the bond markets, which is where investors trade the debt that governments issue to cover their spending.

More specifically, the problem was caused by the inversion of the yield curve, and overnight the media was awash with explanations of what that meant. This in itself was a worrying development. As a general rule, when the argot of the City becomes part of everyday parlance, it spells trouble ahead. No one outside the markets had heard of collateralised debt obligations before they brought the entire banking system to the brink of collapse in September 2008.

Stripped back to its essentials, an inverted yield curve means investors think there is more risk in holding short-term government bonds than long-term ones. Normally it is the other way around, on the grounds that the longer a bond’s duration, the greater the risk.

What’s more, there is a correlation in the US between an inverted yield curve and recession. The last time the yield – in effect, the interest rate –on two-year US treasury bonds was higher than on 10-year bonds was 2007, and within months the world’s biggest economy was plunged into its deepest slump since the Great Depression of the 1930s.

It is by no means always the case that an inverted yield curve leads to a recession. And even when it is the harbinger of bad times, there can be quite a delay before the storm breaks. Stock markets could go on another surge before a recession arrives.

All that said, the market tremors of last week were entirely rational because there is plenty to be worried about. The world’s two biggest economies – the US and China – are in the middle of the most serious trade dispute since the 1930s, one that neither country can win.

Protectionism is having knock-on effects on factory output, not just in China but in the heartland of Europe. Germany, with its industrial motor stalled, has already suffered one quarter of falling growth and could easily be heading for a second.

Not that Germany is Europe’s only headache. There is the long-running saga of Brexit, which looks like coming to a head this autumn.

What is the yield curve?

This is the line plotted on a graph that shows the rate of return on government bonds to their date of maturity. 

Government bonds – known as gilts in the UK, treasuries in the US and bunds in Germany – are debt issued over a fixed period of time, typically three months, two years, 10 years and 30 years, to fund government spending.

The yield is the rate of return investors receive. Maturity is when the government repays the debt at the end of the term. When more investors are buying government bonds prices go up, and yields drop.

Companies can also issue bonds.

What happens when the yield curve inverts?

This is when the yield on short-term bonds is higher than on long-term bonds. It means that traders are accepting a lower interest rate to hold longer-dated bonds than the shorter-dated alternative.

It’s relatively rare – investors typically get higher returns for lending over the long term, as this is seen as riskier than short-term lending. They also expect to be compensated for the impact of inflation, which will eat into investments over time.

What does it mean?

An inverted yield curve is a classic signal of a looming recession – in the US, the curve has inverted ahead of every recession over the past 50 years. It falsely signalled a recession just once, at the time of the 1998 Russian financial crisis.

For other countries the signal is less clear. Several have experienced long periods of inverted yield curves without a subsequent recession, notably the UK in the 1990s.

Why is it happening now?

The yield curve for two- to 10-year US government bonds has inverted for the first time since 2007, just before the start of the global financial crisis. This indicates that investors are seriously worried about an economic downturn, which would keep inflation low. They are worried about the impact on the already-weak global economy of the prolonged trade war between the US and China, along with Brexit.

Is recession inevitable?

No, but it is highly likely. And an inverted yield curve driven by recession fears risks becoming a self-fulfilling prophecy, knocking confidence and causing businesses to cut back on investment.

How soon does recession tend to follow yield curve inversion?

Previous downturns show that yields have typically inverted 18 months, on average, before a recession began. Julia Kollewe

Then there is Italy, which could prove to be an even bigger problem. Italy has been in and out of recession for more than a decade and living standards are barely any higher than when the country became a founder member of the eurozone in the late 1990s. Italy’s populist government would like to borrow more to boost growth, even though that means busting the eurozone’s budget rules, and the country’s de facto leader, deputy prime minister Matteo Salvini, is keen to hold an election that could result in a hard-right government with a mandate to take on Brussels.

Donald Trump’s increasingly vitriolic attacks on the Federal Reserve, the US central bank, are an indication of how fragile things are. The president is keen to have a fall guy in case the economy struggles during his re-election campaign, and has found one in Jerome Powell, the man he chose to run the Fed. Trump says that any damage caused to the economy will be the fault of Powell for raising interest rates too aggressively and being too slow to cut them. The campaign for a U-turn has been successful: the Fed has already started to reduce borrowing costs and looks set to provide more economic stimulus this autumn. Likewise, the European Central Bank has promised a package of measures next month.

Such action will help, at least in the short term, to calm the markets. A comprehensive trade deal between Beijing and Washington would send share prices soaring. But that looks unlikely, and as things stand the question is whether the global economy is heading for a slowdown or a recession.

On average, there has been one serious downturn per decade since the early 1970s. One is due.


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