On 22 March, the biggest news in the financial world was the inversion of the US yield curve. By the end of the day, Google searches for “recession” and “yield curve” had both spiked. It’s not hard to see why – the yield curve has inverted a year before every one of the past seven US recessions.
The yield curve charts the returns investors can expect from putting their money in government bonds with different maturity dates. The yield on a US Treasury bond is determined by the interest rate it offers and the price an investor pays for it, determined by supply and demand. Higher demand makes bonds more expensive, which pushes down their yields.
In general, investors seek a premium for holding bonds that mature over a longer period. Ten-year Treasury bonds should have a higher yield than three-month treasuries because investors expect to be compensated for the risk of lending the government money over a longer period of time. This means that the yield curve usually slopes upwards.
When the yield curve inverts, the returns on a longer-dated bond are the same as those on a shorter-dated bond – in this case, ten-year treasuries are yielding the same as three-month ones. In other words, investors aren’t demanding any more money for lending to the government over ten years than they are over three months.
The reason the yield curve is such a reliable recession indicator is that it reveals investors’ expectations. If they are worried about a future spike in inflation, traditionally associated with high growth, yields on longer-dated bonds will spike. Conversely, if investors aren’t demanding a premium for holding longer-dated bonds it means they don’t anticipate higher inflation, which means they aren’t expecting strong future growth.
The flight into longer-dated bonds – which are considered among the safest assets in the financial system – is also a flight to safety. If investors are uncertain about returns in other areas of their portfolios – such as equities or corporate bonds – they are likely to invest more in treasuries, which at least ensures they will not lose money.
The inversion of the yield curve followed cautious announcements by the US Federal Reserve on 20 March. After cutting its US growth forecast from 2.3 per cent to 2.1 per cent, the Fed announced it was abandoning its 2017 decision to steadily raise interest rates (currently 2.5 per cent) and reverse quantitative easing (QE – the mass purchase of government bonds by central banks).
The Fed’s decision to abandon monetary tightening in 2019 serves as confirmation that normalising monetary policy could tip the economy into recession (as I warned in my recent cover story on “the next crash”) – a remarkable situation at this point in the business cycle. And when the US enters recession, it will likely drag sclerotic Europe and Japan down with it.
Some analysts point out that QE has depressed yields, and is likely to have impacted the reliability of the yield curve as a recession indicator. This is undoubtedly true – and were this merely a case of a yield curve inversion, it might not be such a source of concern.
But there are numerous other storm clouds on the horizon: global trade wars, Brexit, weaker growth in China (around 6 to 6.5 per cent, compared to 14 per cent in 2007) and rising volatility in financial markets across the world. Then there are the unexpected “black swan events”, which we cannot, by definition, anticipate.
Yet the real cause for concern – and indeed the reason that QE was necessary in the first place – is the debt mountain that looms over the global economy. Global debt is now three times the size of global GDP ($244trn) following debt booms among corporations in the US; consumers in the UK, Australia, Canada and the Nordic countries; and almost every sector of the Chinese economy. The reason the Fed is being forced to keep monetary policy loose is that, with private-sector debt so high, further interest rate rises could trigger a recession, and consumer and corporate defaults.
We are living in a zombie economy, in which growth is weighed down by unpayable debts and yet the only way to sustain it is to create more. At some point, this global pyramid scheme will inevitably collapse. And our policymakers – so transfixed by public debt that they have ignored the private debt crisis – are woefully unprepared.
This article appears in the 27 Mar 2019 issue of the New Statesman, Guilty