The bond market appears to be pricing in the risk of an impending recession in the US but fund managers are split over whether this warning should be relied on or not. 
Bond yields have been drifting downwards in recent weeks, with the US 10-year briefly going under 2.10 per cent on 3 June. Some commentators have taken this – along with yield curve inversion – as a sign that there is a high level of fear in the market about the likelihood of a recession.
However, there is a counter-argument that traditional indicators of a recession – such as falling bond yields or an inverted yield curve – are no longer as reliable as they were once thought to be.
US 10yr Treasury yield
Source: Factset, CNBC
David Jane, manager of the £502.8m LF Miton Cautious Multi Asset fund, sees no recession on the immediate horizon. He argued that accommodative monetary environment that was ushered in after the global financial crisis (GFC) has broken the pattern of the bond market’s inverted yield curve being an indicator of a recession.
“US government bond yields are reaching new recent lows while economic data, at least in the US, is surprising to the upside. It’s not meant to be that way but it is,” he said.
“Bond yields offer an indicator of the market’s collective view of future interest rates, at least in theory. It follows that they offer an insight into the market’s view of future inflation and economic growth prospects.
“Given that these have been falling, quite rapidly of late, the market must be expecting a slowdown in growth or inflation or both. However, simultaneously, economic data and leading indicators have been improving following last years’ declines, which is inconsistent.”
One possible explanation for this, according to Jane, is that “old economic theory is wrong”.
The multi-asset manager noted that longer-term bond yields were seen as a representation of what the expected long-term nominal economic growth would be, so their rise and fall was expected to coincide with expected growth and inflation. But this model was established in the pre-GFC era, when bond markets were free of “institutional interference”.
Today, however, central banks are big buyers of government bonds and their main concerns is to avoid a second crisis by creating an accommodative monetary environment. Meanwhile, regulatory capital rules and access to cheap central bank funding mean commercial banks have an incentive to hold government bonds while pension fund regulation has created a huge demand for low risk, long duration assets with income.
Who owns US Treasury securities?
Source: BofA Merrill Lynch Global Investment Strategy, Federal Reserve Board, Treasury Department; ‘other domestic’ includes state & local govt, banks & brokers, GSEs; ‘other foreign’ includes Ireland, Brazil, Caribbean, oil exporting countries
“Looking at markets this way it could be seen as entirely plausible, in the new post-GFC regime, that bond yields could remain extremely low and even fall while economic prospects are improving,” Jane concluded.
“Essentially, in the post GFC new monetary regime, both short and long-term interest rates are structurally lower reflecting excess demand for low risk assets and the high levels of outstanding debt in the system. In short, central bankers are most concerned about another GFC and interest rates not being allowed to rise to levels which cause financial distress.
“Our conclusion is we’re in lower for longer again and will remain so for an extended period, while further refinement of the new monetary regime continues, extending into modern monetary theory and beyond. This implies bond yields are likely to be capped to the upside and the valuations of quality growth stocks can at least persist if not extend further, while economic cycles remain subdued for the foreseeable future.”
Some bond investors do see more risk of markets pricing in a recession. Felipe Villarroel, manager of the £2bn TwentyFour Dynamic Bond fund, pointed out that the main drivers of global markets at the moment is the health of the US economy and the next move of the Federal Reserve.
He said that given recent deterioration in economic data, it is fair to say that the probability of a recession has increased and this has been acknowledged by the market – this doesn’t not mean a recession is definitely on the cards.
One point which Villarroel stresses is that, whilst the economy is currently experiencing a number of indicators of a recession, namely the shape of the yield curve and the slowing rate of growth, it would not be certain that a recession has happened until after it actually occurred.
Villarroel said: “It is important to remember that recessions are an ex-post event [or based on actual events] so we only know about them with a lag of several months. Ex-ante [or based on forecasts], however, if there is a marked slowdown then market prices will most likely discount a recession at some point.”
The manager explained that after the fact, it can then appear the market overshot in its reaction ahead of the recession. This was the case in 2016, when the market seemed to be expecting a recession but it turned out to be nothing more than a slowdown.
“In conclusion, we do not think the US will experience a deep recession. Technically there might not even be a recession, which is not to say that markets won’t price one in,” he said. “But there are enough indicators out there that point to the economy actually being in the later stages of the cycle.”
Chris Iggo, chief investment officer and head of Europe and Asia fixed income at AXA Investment Managers, has a more pessimistic view of what is happening in the economy, saying: “The data is starting to scream ‘downside risks’.”
“This has all escalated very quickly. The environment has become bond bullish and yields are collapsing,” he continued.
“There is a growing anticipation that the Federal Reserve will need to ease policy in the coming weeks and months. If equity markets fall further and credit spreads widen, this could happen sooner rather than later.”
The immediate concern for the global economy is the trade war between the US and China, which has resumed after a relatively quiet period. But this is not the only issue to keep an eye on.
On Iggo’s “long list” of reasons to be fearful are concerns around a lack of inflationary momentum and the effectiveness of the Fed’s monetary policies, the confusion over Brexit and the “long-predicted fragmentation of the British political system”, Italy’s budget disagreement with the EU, increase in geopolitical tensions mostly linked to a more hawkish US foreign policy and the slowing Chinese economy.
Looking at his list of concerning factors Iggo said: “It is clear that recession risks are rising. The consequence of that is that bond yields are likely to keep falling and credit spreads are likely to continue to widen until the US Federal Reserve cuts interest rates.
“I was optimistic that the expansion could continue, but now I am not sure at all. Confidence is eroding amongst businesses and investors.
“For now, locking in the gains made in credit markets already in 2019 looks to be a sensible strategy. On the optimistic side, there could be a trade deal, the world economy might turn out to be more robust than we think and some of the increases in wage rates that have been observed in several countries could eventually feed through to final inflation. But at the moment, this is clutching at straws.”