Are markets signalling that a recession is due?

Canary WharfImage copyright Reuters

Financial markets have flashed a warning sign about the economic outlook for the UK and the US.

It is known in the jargon as an “inverted yield curve”.

It means that it is cheaper for those countries’ governments to borrow for 10 years than for two.

It is an unusual development and it often comes before a recession or at least a significant slowdown in economic growth.

Wall Street shares plunged on Wednesday, as investors’ concerns about a potential recession were stoked by the news.

The main US stock market indexes fell between 1.7% and 2.4%. Meanwhile in Europe London’s FTSE 100 slipped 1.7%, Germany’s Dax lost 2.4% and the French Cac 40 fell by 2.3%.

What is the yield curve?

This warning sign is coming from the bond market, the place where governments and companies go to borrow money by selling bonds.

A bond is a promise to make certain payments in the future, usually a large one when the bond “matures” and smaller ones in the interim, typically every six months.

How much investors pay for the bond determines the yield they will get – the higher the price, the lower the yield.

One factor affecting the yield that investors want is how long they have to wait for the big final payment.

Usually, a longer wait means they expect a higher yield.

It compensates them for tying their money up for longer, when there is more risk that unexpected inflation could erode the value of their returns.

Is it a reliable signal of recession?

What is unusual is that the yield on UK government bonds (gilts, as they are known) with two years to maturity went above the yield on the 10-year equivalent. The same thing happened in the US.

It is seen as a sign that investors want the assured returns from holding a longer-term bond and are worried about the shorter-term outlook for the economy.

Is the inverted yield curve reliable? According to economists at the US Federal Reserve: “Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession.”

The time between the inversion and the onset of a recession is, however, not uniform.

Could this time be different?

That said, there is something about the current situation that didn’t apply to earlier episodes: quantitative easing, the policy pursued by many central banks after the financial crisis (and before, in the case of Japan) of buying financial assets, mainly government bonds.

That had the effect of raising bond prices – which, remember is equivalent to reducing the yield from them.

So QE may well be making a contribution to the yield curve inversion that is taking place now.

The yield curve inversion does not tell us anything about what might be the specific reasons for any impending recession.

What is making the markets so nervous?

This time, there are several possible candidates out there.

The global trade conflict is a factor for many economies. Concerns held by many (though by no means all) businesses and investors about the possibility of a no-deal Brexit are a UK-specific issue that may be contributing.

The UK has just recorded one quarter of declining economic activity, so the idea of an imminent recession is not at all fanciful, although the figures have been influenced by stockpiling ahead of planned Brexit dates and the subsequent rundown of those stocks.

In the US, it would take a significant further slowdown to produce a recession.

Germany has also registered a quarter of declining activity, according to new figures, so a recession could be under way there too.

The yield curve for the German government is not inverted. But there is something else about government bonds there that is a clearly sign of a weak economic outlook: the fact that yields are below zero.

In effect, investors pay the government to lend to it.

That reflects the ultra-low interest rate policy of the European Central Bank, but it is also a sign of a weak economic outlook.

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