Traditional economic theory seems absurd in today’s post-QE environment, writes David Jane.
It’s become an obsession in financial markets to talk about yield curve inversions and the predictive power of forecasting future recessions. However, with the bond market as distorted as it is by ultra-low interest rates and quantitative easing, perhaps the yield curve no longer gives helpful signals.
The yield curve refers to the yields of government bonds at various maturities. Typically, longer maturities will have higher yields, reflecting the greater risk of longer-term lending, as well as higher interest rate sensitivity. Much financial market theory is based on the yield curve; it is used as a pricing basis for bank lending and equity valuation models.
Economic theory suggests that longer-dated government bonds should reflect expectations of longer-term economic growth, on the basis of opportunity cost. By buying a government bond, an investor forgoes the opportunity to invest in the real economy, benefiting from growth and inflation.
Both of the above assertions look absurd in the current post-QE environment. Equities are obviously not being valued on an equity risk premium over bond yields in those markets with negative rates, and I doubt that any forecasters believe that the US will only grow at 1.5% nominally over the next 10 years.
The idea of an inverted yield curve anticipating a recession stems from the concept that if short-term yields are higher than medium- and longer-term yields, then investors are expecting cuts to policy rates. That is, rates are too high to sustain growth and will be lower in the future. Various theories exist based on different parts of the yield curve, two years to 10 years being the most popular. This spread inverted briefly in mid-August, leading to a slew of recession headlines.
It’s not thought that the relationship is causal, inversions don’t cause recessions, but merely a signal that the bond market believes that interest rates will be cut because the economy is weakening. Our difficulty with the whole concept of bond market signals is that these may have been worthwhile in a world where bond yields were set principally by the market, but this is no longer the case.
We are in a post-QE world where there seems to be a race to the bottom for interest rates and yields. It seems unreasonable to simultaneously believe that bond markets give a forward-looking economic signal, and that bond yields have been manipulated artificially lower. Both cannot be true.
It is fair to say that the current yield curve is signalling slower future growth than was previously expected and policymakers will likely be cutting rates over the coming months. We would, however, question whether the flatness of the curve further out reflects expectations of interest rates, inflation and growth in the future or whether it more reflects a desperate search for yield by investors starved of opportunities by central bank intervention.
This artificiality might, therefore, be leading investors to panic unnecessarily about the economy’s prospects further out because we find it hard to believe that long-term rates are giving a true signal of long-term growth prospects and inflation, particularly in the US. In short, you can’t have it both ways.
David Jane is manager of Miton’s multi-asset fund range.