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It was quite a scary financial chart that spooked financial markets at the end of March – even more disconcerting than the usual charts depicting a retreating rand against the dollar or the slide in the property index on the JSE.
The chart depicted the “inverted” yield of the three-month US Treasury compared to the benchmark ten-year, meaning that the yield in the three-month rose above that of the ten-year.
This phenomenon flies against all known money theory and financial knowledge about the market.
Yields on longer-dated treasuries are usually higher than short-term treasuries due to the inherent risk over the longer term, for which investors need to pay a higher yield premium.
When the ten-year yield fell to 2.4% and the three-month rose to 2.5%, it meant that investors saw less risk over the longer term than over the short term.
Therefore, negative short-term conditions necessitated selling for more safe-haven comfort over the longer term.
This is a very unusual and negative development.
A recession has always followed the selling of short-term bonds in favour of long-term investments in an inverted manner.
The most recent being in 2006, before the Great Recession of 2008.
It’s not simply a quirky happening.
It is real, and based on economic realities where money is getting tighter due to interest rate increases already implemented.
With inflation set to fall over the longer term, it justifies buying longer-term bonds at the expense of short-term instruments.
The “inverted” yield foretells a recession in a year or 18 months down the line.
The market is now pricing in tighter monetary conditions, but also lower GDP growth going forward – partly as a result of rates in the US having risen to a present 2.5% from near zero a decade ago.
In the US, economic growth has already fallen to 2.2% from 3% last year, indicating that further reversals may be lurking.
This while the US Federal Reserve (Fed) remains committed to further normalisation of monetary policy, with another one to two hikes indicated, although it has “paused” for now.
An equally disconcerting development relating to the “inverted” phenomenon has been German ten-year Bund yields falling below zero for the first time this year.
The Japanese ten-year has been in negative territory since February, yielding a negative 0.08%.
This means an investor will receive no return on their money.
The investment is solely done to benefit from safe-haven considerations.
So great is the concern about future risk in equity markets that investors are prepared to place their money in instruments where they’ll receive no return at all.
This means investors have no confidence in equity markets, which are foreseen to fall over the next few months, despite recovering on average with double-digit growth since the beginning of the year.
Equity valuations are deemed too high at present, considering the overall economic picture.
On face value, it may seem as if bond markets were overreacting as US interest rates are technically still just below the supposed neutral level of 2.8%.
And it may be that markets are pricing in lower interest rates rather than a recession, as previous Fed chair Janet Yellen said.
In fact, the inverted yield corrected itself soon thereafter with the ten-year yielding more than the three-month again.
But the movement was marginal and tentative.
It seems unlikely that the pattern of mid-2013 will repeat itself soon.
In May 2013 the US ten-year yield fell to 1.6% after then chair Ben Bernanke indicated that quantitative easing (QE) would fall away.
When he backtracked, the yield shot up to 3% again, much like at end-2018 when the ten-year spiked to 3.2% on the Fed’s confidence about the US economy.
How things have changed.The Fed has not yet reacted much to the surge in the bond market, other than “pausing” with further hikes.
Fed chair Jerome Powell has seemingly dug in his heels by continuing with its “normalisation” stance, coupled with the proviso that any further hikes will be data dependant.
This has not soothed the bond market.
The eventual move in rates is sure to be down, even if the Fed remains obstinate and hikes rates one more time to 2.75% over coming months.
The bond market is expected to react in kind, pushing down yields on the US ten-year further to a possible 2.03%, according to Nedbank Corporate and Investment’s technical analysts.
Savvy and forward-looking investors have already positioned themselves accordingly.
The surge in bonds indicates equity markets will be hard-pressed to sustain further gains and at some point will have to start factoring in a recession in 2020 or 2021, meaning a weaker share market.
That is when these astute investors are set to pounce, shifting out of bonds into equities again, snapping up shares at lower prices.
Indications are that the coming recession might be mild, more in the mould of the early 1990s than the deep 2008 crisis.
Whatever the case, as usual, it will be the average investor that will be the hardest hit.
At the moment little can be done, other than to sit it out and see how the power struggle between the Fed and the bond market pans out.
Maarten Mittner is a freelance financial journalist and a markets expert.
This article originally appeared in the 18 April edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
