The danger of talking yourself into a recession
Last week’s inversion of the yield curve in the US spooked markets. Investors received less yield for the 10-year treasury than for those with a duration of two years. The last time this happened was 2007, at the outset of the financial crisis. Inverted yield curves have traditionally signified that recessions would follow within 12 to 18 months.
It should come as no surprise that this has alarmed investors. The Dow Jones Industrial index lost around 3.3 percent between Aug. 13 and 16. It recovered some and ended just shy of 26,000 on Friday evening. The carnage was even worse for other bourses.
An inverted yield curve often causes a lot of concern, but it need not be a harbinger of doom. In this case, the drop in yield of the 10-year treasury can be partially explained by demand. Term investors like pensions funds were seeking secure investments of longer durations to insulate themselves from the vagaries of geopolitics and trade wars. This means that they were willing to pay a premium and forego some yield to hold the 10-year paper.
However, this explanation does not bode for confidence in the economy. Investors do not need to observe the inversion of the yield curve to understand sentiment; they can also consult their gut feeling. US rating agency Standard and Poor’s said that the probability of a recession in the US had reached 30 percent over the last few weeks. The culprits for this increase are trade wars and a weakening of the industrial sector. Indeed, the US purchasing managers index (PMI) hovers around 50, which is precisely the demarcation between growth and contraction of the industrial sector.
The significance of the PMI for the US economy is tapered by the fact that the sector only accounts for 12 percent of GDP. At 3.7 percent, unemployment is still at a record low and consumer confidence surged by 0.7 percent for the month of July. President Trump’s economic adviser, Larry Kudlow, hit the airwaves on Sunday to assert that there was no recession on the horizon.
Axa Chief economic adviser and economic sage Mohamed El Erian made a pertinent point in a Bloomberg column. He highlighted the danger of “spooking investors with breathless coverage of the yield curve inversion.”
An inverted yield curve often causes a lot of concern, but it need not be a harbinger of doom.
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He has a point: If investors are scared, they will invest less, consumers will purchase less and we could end up in a vicious circle. He observed that bond markets are internationally more connected than national economies, which explains why the yield curve inversion in the US had such a ripple effect through global stock markets.
Panic is never a good sentiment in international markets; El Erian’s wise words came at a good time. Investors should also be beware of exuberance. Kudlow’s comments can be put in that category. Consumer confidence and unemployment rates are one thing. However, the dark clouds of protectionism are gathering and this brings significant risk of slowing down the global economy.
This brings us to what central banks can do. There is huge pressure on Federal Reserve Chairman Jerome Powell to continue lowering rates. There are two schools of thought: Prudent observers are concerned that lowering the base rate again would be tantamount to squandering a valuable tool while the going is still relatively good.
Others are concerned that following the financial crisis, the Federal Reserve has few quivers left in its arsenal and therefore needs to prevent a recession at all costs. They recommend a rate cut of 50 basis points in September to get ahead of the story. Subscribers to that view should recall that tiny or negative interest rates and ever-expanding balance sheets of central banks did little to foster economic growth in Japan or Europe.
Last week has certainly given food for thought to the central bankers who will gather at their annual Jackson Hole retreat later this week. Stay tuned.
• Cornelia Meyer is a business consultant, macro-economist and energy expert. Twitter: @MeyerResources