Who’s afraid of the yield curve?
* There’s no doubt that growth in the West is slowing. The question is whether the slowdown could turn into a recession. Last month the US yield curve, a key gauge of future US growth, temporarily dipped into recessionary territory for the first time in ten years.
* It barely caused a ripple elsewhere, but in the world of economics an inverted yield curve is big news. This week’s Briefing asks whether the yield curve is signalling that tougher times lie ahead for the global economy.
* The yield curve measures the gap between the interest rates (or yields) on three-month and ten-year government bonds. Central banks largely determine short-term interest rates. Long-term yields are influenced by market expectations for growth and inflation.
* When markets anticipate a slowdown, expectations for growth and inflation fall, dragging down ten-year yields. In the jargon this is a flattening of the yield curve. When ten-year yields fall further, below three-month rates, as they did in the US briefly last month, the curve is inverted. This signals that markets think that short-term interest rates are too high.
* Each of the last seven US recessions have been preceded by an inverted curve. This is an indicator with form. So how serious are the risks this time?
* Some think the yield curve no longer works as an indicator of recessions. They point out that bond yields have been falling for more than a quarter of a century, driven by a series of secular forces. Demand for bonds has soared as central banks have hoovered them up via Quantitative Easing. Pension funds and banks have had to increase their holdings of bonds for regulatory reasons. Increased demand means lower yields or interest rates on bonds. Falling long-term expectations for growth and inflation have added to the downward pressure on yields. To the sceptics, a long-term decline in bond yields means that the yield curve has lost its power to forecast recessions.
* Yet we should not write it off altogether. After all, the yield curve has a better record of forecasting recessions than economists, or the Federal Reserve. The argument that new forces are reducing the supply of bonds, or increasing the demand for them, have been around for at least 20 years. That didn’t stop the yield curve from signalling the last three US recessions.
* So where does that leave the outlook for US growth? On average, economists see the US growing by a respectable 2.4% in 2019 and 2.0% in 2020. But the risks of things turning out weaker have increased. The Cleveland Federal Reserve’s model, based on the yield curve, assigns a 30% probability to the US falling into recession in the next 12 months. That is the highest probability since before the financial crisis.
* Two things would need to happen to make us significantly more nervous on US growth.
* First, the yield curve would need to stay inverted for far longer than the few days that were seen in March. Most recessions are preceded by several months of yield curve inversion.
* Second, other lead indicators for the US would need to turn weaker. Measures of equity market volatility, financial stress, credit conditions and jobless claims do not signal a recession.
* Yet, whatever the ifs and buts, a negative yield curve is not good news. As such, it adds to the case for the Federal Reserve to keep US monetary policy looser for longer. It is no surprise that financial markets’ expectations for US interest rates have fallen sharply in the last six weeks.
* It’s far too early to predict a recession. But it’s not too early to worry about one.
OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 2.3% at 7,279 as global markets strengthened on positive data from the US and China
Economics and business
* Saudi Aramco, the state-owned oil company, has revealed it generated a net income of $111bn last year, making it the most profitable company in the world
* A UK survey of purchasing managers showed a sharp increase in manufacturing activity, thought to be caused by Brexit stockpiling
* In a further sign of weakness in the German economy, manufacturing activity, as measured by the Purchasing Managers’ Index (PMI), contracted at its fastest pace since 2012
* Chinese manufacturing activity rebounded in March as measured by the Caixin PMI
* Jonathan Lavine, co-managing partner at Bain Capital, warned that private equity firms are over-leveraged, raising the risk of a crash
* The UK minimum wage rose last Monday to £8.21 per hour for over 25s, continuing a trend that has seen the UK have one of the highest minimum wages amongst major industrialised countries
* Eurozone inflation fell to 1.4% in the year to March from 1.5% in February
* In a sign of changing consumer tastes, the meat-alternative company Impossible Foods has signed a deal with Burger King to distribute an ‘impossible whopper’
* The US Department of Justice has warned that changes to Oscars’ eligibility rules designed to exclude films released on Netflix may violate antitrust laws
* New York has introduced a congestion charge on drivers, partly as a response to the increasing popularity of taxi-hailing apps
* UK firms have published figures on their median gender pay gap, with the overall gap largely unchanged from last year
* US President Donald Trump has recommended Herman Cain, who previously ran for the Republican presidential nomination, to join the Federal Reserve board
* A US-China trade deal is now not expected to be finalised until at least May, according to comments by US President Donald Trump
* The US added 196,000 jobs in March, rebounding from only 33,000 in February
* UK labour productivity fell by 0.1% in the fourth quarter last year, continuing a trend of disappointing productivity growth since 2007
* The World Trade Organisation has forecast slower trade growth this year due to slowing growth in major economies and tensions over trade
* The Financial Conduct Authority, a British regulator, has warned consumers over the risk of peer-to-peer loans
Brexit and European politics
* UK prime minister Theresa May wrote to Brussels last Friday requesting a Brexit delay to 30 June. In her letter, she indicated she wished to avoid participation in European elections and hence would aim to leave by 23 May
* Mrs May however acknowledged that to stay past 23 May, European elections would need to be held and so preparations for these would be undertaken
* This follows further impasse in the House of Commons last week, with further indicative votes last Monday again failing to find an alternative way forward
* Mrs May announced she would work with the leader of the opposition, Jeremy Corbyn, to consider alternative versions of Brexit that could secure parliamentary support
* Viable alternatives are widely interpreted to involve closer alignment with the EU than envisaged in Mrs May’s current Brexit deal
* Labour and Conservative party talks took place in the second half of last week, with no sign of a breakthrough at the time of writing
* Relations within both main parties in the UK are now strained, with Brexit-supporting MPs in the Conservative Party angry at the move towards a softer Brexit and some Labour MPs critical of their party being seen to facilitate Brexit
* European Council president Donald Tusk proposed a “flextension” of up to a year, allowing an earlier exit if the withdrawal agreement was ratified
* There are concerns in the EU, notably from France, that the continued membership of the UK would interfere with EU decision-making
* Participation of the UK in European elections would also be hugely disruptive, with seats being vacated by British MEPs already reallocated
* The decision on whether to grant a further extension will be taken in the European Council meeting on Wednesday evening
* Barring revoking Article 50, the UK is still currently set to leave on 12 April if no further extension is agreed
And finally… To the anger of vegans, vegetarians and environmentalists, the European Parliament will consider if meat-substitute producers should be banned from describing their products as steaks, sausages, escalopes or burgers – regulation at its wurst?