Bond Markets Really Are Signalling a Slowdown
When it comes to the economic outlook, the bond market is smarter than the stock market. That Wall Street adage appears to be on the money from a cyclical vantage point, with key indicators in the fixed-income markets independently corroborating slowdown signals from the Economic Cycle Research Institute’s leading indexes.
The yield curve is widely considered to be among the most prescient indicators. That’s why its flattening this year has been troublesome for an otherwise optimistic consensus to explain away.
This hasn’t stopped optimistic analysts from dismissing the yield curve’s message on the grounds that inflation expectations have been declining in recent years, or that foreign central banks like the European Central Bank and the Bank of Japan continue to artificially suppress their bond yields, pulling down U.S. yields. We’re reminded of Sir John Templeton’s warning that “this time it’s different” are the "four most costly words in the annals of investing" -- but that’s effectively what it means to simply ignore the slowdown signals emanating from the fixed-income markets.
Of course, there’s no Holy Grail in the world of forecasting, which is why we look at a wide array of leading indexes that each includes many inputs. From that vantage point, the yield curve flattening actually makes a lot of sense. Growth in ECRI’s U.S. Short Leading Index, which doesn’t include the yield curve, has been falling since early this year (top line in chart), pointing to a U.S. growth rate cycle downturn that should become evident in coming months.
Next, please note the separate slowdown signal coming from the difference between the yields on junk bonds and investment-grade corporate bonds -- also known as the quality spread (middle line, shown inverted). It has widened in recent months because the rising default risk for junk bonds during economic slowdowns makes their yields climb faster than those of investment grade bonds, which are less likely to default.
That the quality spread has little to do with the term spread is telling. Please note how closely the (inverted) quality spread has followed the Short Leading Index growth rate, not only this year, but also in past cycles.
Finally, we turn to the term spread between 10-year and two-year Treasury yields, which has been falling all year (bottom line), flattening the yield curve. Again, this is being dismissed by some analysts who attribute the phenomenon to foreign central banks' suppression of their bond yields, even though this is nothing new. And while declining longer-term inflation expectations and trend growth expectations help explain the long-term downtrend in the term spread, they don't explain its cyclical fluctuations.
Of course, the quality spread doesn’t exhibit a similar long-term downtrend. That’s because it’s unaffected by both foreign monetary policy and the years-long downgrading of long-term growth and inflation expectations.
Nevertheless, the chart shows that the cyclical ups and downs of both the quality spread and the term spread have followed those of the Short Leading Index's growth rate. In other words, our leading indexes, as well as two very different bond market spreads, are telegraphing an economic slowdown that nobody sees coming. It certainly threatens to blindside the Fed, which -- fixated on the Phillips curve -- keeps projecting multiple rate hikes over the next year.
There’s a choice. Perhaps it is different this time, with the Fed, the stock market and Wall Street analysts all outsmarting the bond market and ECRI’s leading indexes. Or you can heed these slowdown signals, and begin thinking through the implications.
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Max Berley at email@example.com