Fears that bond market could be pointing to US recession
5 December 2018, 17:16 | Updated: 5 December 2018, 18:21
It is regarded as one of the most fail-safe ways to predict a future recession – and all Wall Street is watching nervously.
"Yield curve inversion", as it is known, is the situation when yields (a measure of the return an investor receives on a bond or share) are higher for a short-dated bond than a long-dated bond.
That is happening at the moment in the market in US treasuries, the biggest and most liquid financial instrument in the world.
Two-year US treasuries - those bonds where investors will receive their money back from the US government two years after buying them - were yielding 2.8110% at the close of trading on Tuesday evening.
By contrast, five year treasuries were yielding 2.799%.
In other words, investors are demanding a greater return for the risk of having their money tied up in US government bonds over the next two years than they are for holding those assets over five years.
It was enough to spark sharp falls in US stock markets.
The "yield curve" - a line plotting the interest rates at a set point in time of bonds with equal credit quality but differing maturity dates - should, under normal circumstances, show bonds with a longer maturity having a higher yield than those with a shorter one.
That reflects the risk of holding the bond over a longer period of time and it is very rare to see a yield curve "inverted".
The last time this phenomenon was seen was from the beginning of 2006 to mid-2007 - just before the financial crisis tipped the US economy into recession.
There was a similar inversion seen between the beginning of 2000 and early 2001 - which again pointed to a recession from March to November 2001.
This phenomenon may sound fairly abstract - but it has a real-world impact.
Banks like to borrow money on a short-term basis and lend it out on a long-term basis.
They make their turn - or "net interest margin" - from the different interest rates on the two transactions.
However, if interest rates are higher in the short term than in the longer term, that erodes the margins of the banks and hits their profitability.
It makes the banks reluctant to lend and, in some cases, stops them from doing so altogether.
Accordingly, yield curve inversions are seen as a good predictor of a recession.
According to Jefferies, the broker, inverted yield curves have predicted each of the last seven US recessions dating back to the 1960s.
The typical period elapsing between the inversion taking place and the recession kicking in, it says, is just over 21 months.
On that basis, the next US recession would begin in September 2021 with the S&P; 500, the main US stock index, beginning to fall from around March that year.
For the most recent three US recessions, though, the period between yield curve inversion to recession has been shorter at between 13-15 months.
Yet not everyone is convinced that this unusual occurrence justifies stock market investors heading for the exit.
The first key point is that five year bonds are not really regarded as "long-term" debt but medium term.
The yield curve inversion that would most rattle investors would be where the yield on two-year treasuries was higher than that on 10-year treasuries.
That point has not yet arrived.
For most of the last decade, the yield on 10-year treasuries has been at least two percentage points more than the yield on two-year treasuries.
But the gap between the two fell below one percentage point in May last year and has continued to fall since.
On Tuesday, it fell to just nine basis points, or just under one-tenth of one percentage point.
Some argue that, because the US Federal Reserve is beginning to unwind its $4.5tn worth of asset purchases - Quantitative Easing in the jargon - made in the aftermath of the financial crisis, there is bound to be a level of disruption in the bond market that leads to odd price moves.
Others say there is nothing to worry about because, as the end of the year approaches, December often sees unusual movements in stocks, bonds and currencies as fund managers lock in their gains for the year.
And at least two former chairmen of the US Federal Reserve, Alan Greenspan and Ben Bernanke, have argued that yield curve inversion should not be treated as the accurate predictor of a recession that once it was.
This sudden inversion between two and five year treasuries has, though, taken a lot of bond traders by surprise and they are struggling to rationalise what has caused it.
A couple of factors come to mind.
One is the realisation, on Tuesday this week, that the supposed "deal" agreed between Donald Trump and Chinese President Xi Jinping at the G20 summit last weekend was nothing of the sort.
A truce has merely been declared in the trade war and further tariff increases next year remain possible.
The second is that the US Federal Reserve, despite immense pressure from Mr Trump, is still raising interest rates.
Most market watchers expect it to raise interest rates later this month and then again in June next year.
There are nerves that, with a trade war still raging and the Fed raising interest rates, the US economy could slow down more sharply than expected in 2019.
At the moment, then, the inversion in yields between two and five year Treasuries does not have everyone convinced a recession is looming.
One between two and 10-year treasuries might.
(c) Sky News 2018: Fears that bond market could be pointing to US recession