First this anomaly hit the United Kingdom, then the United States, Australia, New Zealand and now, Canada.
It's known as a "yield-curve inversion." It happens in the bond market when short-term interest rates (or yields) move higher than long-term rates, which is NOT the norm.
Typically, bonds with longer dated maturities carry higher rates of interest than short-term notes or bonds. That's because time is money ! You take on more risk holding long-term bonds, because it takes more time to collect all those interest payments and get your principal paid back at maturity.
An inverted yield curve like we have right now is an unusual, and a potentially troubling situation; pointing to economic weakness ahead. In fact, this anomaly has been an accurate barometer forecasting economic recessions since WWII. In all but one instance over the last 60 years, an inverted yield curve has correctly forecasted a coming recession.
This Anomaly Is Spreading Like a Plague
Now, several Anglo-Saxon economies, which tend to historically march to the same economic drum, are in the midst of yield-curve inversion. The latest victim is Canada.
The Canadian yield-curve recently became inverted as short-term and long-term interest rates converged for this first time in this economic expansion.
Indeed, it's been a great ride for Canadian stocks and the Canadian dollar over the last four years. Economic growth has boomed, budget surpluses have swelled and the country has reduced its external debt. But if the economy is so red-hot, why are Canadian bonds inverting? Benchmark two-year Canadian government bonds now yield 4.23% versus only 4.22% for 10-year bonds.
The same phenomenon has already occurred in the United Kingdom since last year. Benchmark ten-year British gilts now yield an effective 5.13% compared to 5.57% for two-year gilts.
In Australia, two-year debt yields 6.23% compared to 5.91% for 10-year bonds. And in New Zealand, two-year bonds fetch 7% versus 6.16% for 10-year debt.
What's Causing This Anomaly Worldwide
It's possible these yield-curve inversions are happening because of the booming financial markets around the world, with increased cross-border capital flows. All these investment assets are seeking a home in fixed-income securities, including government debt, which drives bond yields down.
Also, with high-risk bonds like junk debt and emerging market bonds yielding the lowest spreads over government bonds in history, pension funds are probably another factor driving government bond yields down as they seek relative safety and yield.
Another observation partially explaining the yield-inversion phenomenon is strong currencies in most countries.
With the exception of the United States since 2002, strong currencies tend to import deflation. That's the case in Australia, New Zealand, Canada and even the United Kingdom, which complains inflation is too high. And in reality, British consumer price index (CPI) is historically low. A strong currency attracts international fund flows, driving the currency higher and compressing bond yields. That's another possibility for the yield-curve inversion.
But it's not just the English-speaking economies that harbor yield-curve inversion and recession risk.
Germany, Europe's largest economy, is in the midst of its strongest economic expansion this decade. And right now, Germany is just five basis points (0.05%) away from yield inversion. Other members of the euro-zone naturally harbor the same interest-rate fundamentals and are also close to inversion.
Why the Bond Market's Opinion Matters
Bonds are where the smart money trades and invests. Although the stock market acts as a discount mechanism, typically forecasting economic events six months or so before they occur, it's not a reliable barometer. Bonds, on the other hand, are far more sensitive to economic data and that's where the "big" money lies.
Right now, bonds are warning of economic recession in the United States and throughout most of the G-7, except Japan. If bonds are right, we're at the cusp of a recession later this year, which implies increased stock market risk too. That's what bonds are saying now.
It's known as a "yield-curve inversion." It happens in the bond market when short-term interest rates (or yields) move higher than long-term rates, which is NOT the norm.
Typically, bonds with longer dated maturities carry higher rates of interest than short-term notes or bonds. That's because time is money ! You take on more risk holding long-term bonds, because it takes more time to collect all those interest payments and get your principal paid back at maturity.
An inverted yield curve like we have right now is an unusual, and a potentially troubling situation; pointing to economic weakness ahead. In fact, this anomaly has been an accurate barometer forecasting economic recessions since WWII. In all but one instance over the last 60 years, an inverted yield curve has correctly forecasted a coming recession.
This Anomaly Is Spreading Like a Plague
Now, several Anglo-Saxon economies, which tend to historically march to the same economic drum, are in the midst of yield-curve inversion. The latest victim is Canada.
The Canadian yield-curve recently became inverted as short-term and long-term interest rates converged for this first time in this economic expansion.
Indeed, it's been a great ride for Canadian stocks and the Canadian dollar over the last four years. Economic growth has boomed, budget surpluses have swelled and the country has reduced its external debt. But if the economy is so red-hot, why are Canadian bonds inverting? Benchmark two-year Canadian government bonds now yield 4.23% versus only 4.22% for 10-year bonds.
The same phenomenon has already occurred in the United Kingdom since last year. Benchmark ten-year British gilts now yield an effective 5.13% compared to 5.57% for two-year gilts.
In Australia, two-year debt yields 6.23% compared to 5.91% for 10-year bonds. And in New Zealand, two-year bonds fetch 7% versus 6.16% for 10-year debt.
What's Causing This Anomaly Worldwide
It's possible these yield-curve inversions are happening because of the booming financial markets around the world, with increased cross-border capital flows. All these investment assets are seeking a home in fixed-income securities, including government debt, which drives bond yields down.
Also, with high-risk bonds like junk debt and emerging market bonds yielding the lowest spreads over government bonds in history, pension funds are probably another factor driving government bond yields down as they seek relative safety and yield.
Another observation partially explaining the yield-inversion phenomenon is strong currencies in most countries.
With the exception of the United States since 2002, strong currencies tend to import deflation. That's the case in Australia, New Zealand, Canada and even the United Kingdom, which complains inflation is too high. And in reality, British consumer price index (CPI) is historically low. A strong currency attracts international fund flows, driving the currency higher and compressing bond yields. That's another possibility for the yield-curve inversion.
But it's not just the English-speaking economies that harbor yield-curve inversion and recession risk.
Germany, Europe's largest economy, is in the midst of its strongest economic expansion this decade. And right now, Germany is just five basis points (0.05%) away from yield inversion. Other members of the euro-zone naturally harbor the same interest-rate fundamentals and are also close to inversion.
Why the Bond Market's Opinion Matters
Bonds are where the smart money trades and invests. Although the stock market acts as a discount mechanism, typically forecasting economic events six months or so before they occur, it's not a reliable barometer. Bonds, on the other hand, are far more sensitive to economic data and that's where the "big" money lies.
Right now, bonds are warning of economic recession in the United States and throughout most of the G-7, except Japan. If bonds are right, we're at the cusp of a recession later this year, which implies increased stock market risk too. That's what bonds are saying now.
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See How the British Consumer is being screwed
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