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Bonds Are Screaming A Warning: Should Investors Be Listening?


Following the recession, central banks around the world used bonds of various kinds as tools in their attempts to reflate the global economy. With hindsight, that seems to have worked, even despite fiscal policies that were generally unhelpful.

But there has been one big negative. The massive purchases of bonds made by the Fed, the ECB and others and then the sale of them to reduce their bloated balance sheets have distorted the bond market. Drawing conclusions from bond market moves has been hard, and often dangerous, for around a decade. Still, what we are seeing this morning is different.

The yield curve is now fully inverted from 1-Month out to the benchmark 10-Year rate.

Interest rates vary depending on the length of time to maturity of a bond. Generally, when people tie up their money for a longer period of time, they demand a little more annual interest to compensate for that, so longer dated bonds have higher interest rates than short-term paper.

If, therefore, you plot a chart with interest rates on the vertical axis and time on the horizontal, you would normally see a curve that slopes gently upward from left to right.

Now, that curve, from 1-Month out to 10-Years, slopes downwards.

Given the natural tendency of rates to increase along the curve, that has always been thought to indicate economic problems ahead. It suggests that the Fed is expected to cut rates in the future, something they do in response to a recessionary environment.

When the curve was simply flattening, with a small amount of inversion at the front end, it was, as I pointed out here, wrong to read too much into that. The massive programs of bond-buying known as Quantitative Easing (QE), that were undertaken by the Fed and other central banks in response to the recession, look justified with hindsight, but the bond market started to respond to the Fed’s actions rather than economic conditions.

Treasury prices, and therefore yields, have been moving based on the short-term influences of the Fed buying and selling securities and on attempts to normalize what were once near-zero interest rates. As I said in the above referenced article, a case could even be made that the expectation of flat interest rates that prevailed was a good thing, indicating that the Fed was in control and able to avoid the “boom and bust” cycles that had existed before QE.

What we are seeing this morning, however, is different.

We have gone from a flattening curve to full inversion. In other words, the bond market is not just implying stability in interest rates, it is of the opinion that they will be cut before long. That is normally a bad signal, but, given that the Fed is still trying to raise rates back to more normal levels, it is particularly significant.

Nor are Treasuries the only part of the bond market that is flashing a warning. German government bonds, known as Bunds, have turned negative again, indicating that for many big investors, return of capital is now far more important than return on capital. The dollar too, after understandably losing ground when the Fed announced this week that there would be no rate hike this month and that further increases were being delayed, bounced right back. There are many reasons that people might buy the dollar, but its role as a safe haven in times of economic turmoil is a major one.

Just about every market that can is flashing a warning signal that tough economic times are coming, and probably are not too far away. The exception, however, is the stock market. There, we have been pushing back up towards last year’s all-time highs.

It is possible, of course, that that is the correct take on prospects, but a couple of decades in dealing rooms around the world taught me that when the bond and forex markets speak clearly and in unison, that is the voice that all traders should be listening to. Assuming that is true here, stocks will catch up, so trimming positions and/or some kind of hedge may be a good idea for investors before long.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.





This article appears in: Investing , Bonds , Central Bank , Economy , Investing Ideas , Stocks , US Markets




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