Sunday, May 27, 2007

Speaking of "the housing market in Britain [being] overvalued by up to 65%"

Bond Market Speaks Volumes about Recession Risks Ahead

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 [sic] a coming recession.

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.

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 [inflation] 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. [...]

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.

By Eric Roseman, editor of Commodity Trend Alert and Global Mutual Fund Investor, for the Sovereign Society.

5 Comments:

Blogger Oroborous said...

Another example of "importing deflation" would be the yuan peg to the U.S. dollar, which has caused Chinese-made goods to be really, really cheap by American standards.

While Harry would say that such stuff is "badly made and undesirable", (paraphrasing), that has not been my experience.

But I don't own or buy a lot of goods, mostly services, so maybe he knows better than I do.

In any case, the availability of such goods has caused the rate of inflation in America to have been depressed by around a full percentage point, for over a decade.

May 27, 2007 6:44 AM  
Blogger David said...

It's not really inverted, it's just weird. To me, the weirdest thing is the fall in rates between 20 year Notes and 30 year Notes. The only explanation I can think of is that there must be a huge flight to quality bidding up the 20 year Notes.

May 28, 2007 9:03 PM  
Blogger Ali said...

It's hard to say if this is a harbinger of recession. Asset values are overcooked everywhere and there's a global chase for yield that seems to have thrown risk consideration out the window, but the excess liquidity in global capital markets combined with China's deflationary impact is unprecedented AFAIK.

May 29, 2007 2:40 AM  
Blogger David said...

That is to say, a flight for quality to the 30 year Note has pushed down that rate.

May 29, 2007 5:07 AM  
Blogger Oroborous said...

I think that the yields are inverted. A couple of economic/business analysts/economists whose opinions I respect think that the best comparison is the spread between the 1yr vs. the 10yr, because the 20 and 30yrs attract a lot of money from pension funds and insurance companies who are looking for safety above all else, which, as David notes, skews the yields a bit.

By the 1yr/10yr standard, there is an inverted yield curve.

Further, look at the spreads for all maturities. The 2yr and 10yr are basically at par, and the biggest spread between the 3, 5, 7yrs vs. the 10yr is a paltry 6 basis points.

Also, the 6mo. pays more than the 1yr, which pays more than the 2yr, which pays more than the 3yr, which pays more than the 5yr...

To show further how screwy the yields are, here are some historical data points, from non-recessionary years selected at random (notice the orderly yield ladder):

............1mo 3mo..6mo 1yr..2yr...3yr..5yr
05/27/97 N/A 5.18 5.50 5.89 6.30 6.47 6.64
05/25/05 2.67 2.93 3.19 3.34 3.64 3.75 3.94
05/25/07 4.97 4.88 4.97 4.93 4.85 4.81 4.80

.............7yr..10yr 20yr..30yr
05/27/97 6.73 6.79 7.12 7.03
05/25/05 4.08 4.26 4.65 N/A
05/25/07 4.82 4.86 5.09 5.01

May 29, 2007 8:55 AM  

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