The “R” word (“recession”) has been rearing its ugly head again of late, as global bond yields have renewed their decline.  With the stock market at an all-time high in the US, and near all-time highs in many other developed markets, as well as record or near-record low unemployment rates, how can we possibly be talking about a recession?   The reality is that in almost every recession seen in the past 40 years, it was preceded by very buoyant equity markets and very low unemployment.  Given that this is the case today, what can we look at as an indicator of things to come?

The good ‘old’ days

Cast your memory back to 2017 up until the fall of 2018.  The market saw an increase in bond yields across virtually all of the developed markets (plus China).   In some cases, on a percentage change basis, these increases in yield were very significant.  As Chart 1 below shows, the UK 10 yr Gilt yield more than tripled, from 0.5% to 1.6%, US 10 yr yields went from 1.5% to 3.2%, and Eurozone 10 yr yields rose from negative 0.15% to positive 0.7%.  The world economy was looking almost healthy, with signs of inflation starting to show.  Enter Trump’s trade wars, Brexit battles, and renewed concerns over global growth.

What goes up must (or at least, will eventually) come down

Since the start of autumn of last year, we’ve seen bond yields come lower across the world.  Lenders are willing to get lower and lower yields when lending to governments.  Why? Signs of inflation as seen in traditional economic data have all but disappeared, and fears of a global slowdown and potential recession have risen.  In many cases yields are now lower than where they were before the rally in yields started back in late 2016.  In fact, Eurozone 10-year yields have joined Japanese yields in negative territory.  That’s right, investors are willing to lend the governments of Japan and the Eurozone money today, even though they realize that they will get less money back at the end of the loan period!  

Chart 1:  Developed Market 10-Year Bond Yields

Does this point to a global recession?  One of the most accurate predictors of recessions is the 2-year – 10-year yield differential.  As can be seen on Chart 2 below, the 2s/10s yield spread went negative before each of the US recessions (vertical grey bars) experienced over the past 40 years.

Chart 2: US: 10-Year Treasury Constant Maturity Minus 2 Year Constant Maturity Bond Yields

What does the 2’s 10’s indicator show us today?

As can be seen by chart 3 below, although there is only one country with a negative 2’s 10’s yield spread (that is Canada, which is surprising given that the Canadian Dollar is the top performer in the G10 vs USD this year!), every country included in the chart is trending towards zero in this measure.  It may be that these countries never get to zero, but as the chart above shows, these downward trends in the yield spread only reverse once it trades in negative territory, so while we’re not there yet, it sure feels like we’re going there!

Chart 3: 10-Year Yields Minus 2-Year Yields

We often hear people say the phrase: ‘It’s different this time”.  As someone who has been around these markets for over 25 years, my view is that the only thing that’s different is the speed at which events take place now.  The yield curves are pointing to a coming recession, at least in some countries.  Whether that will turn into a global recession is a difficult question to answer, but there will surely be a global slowdown if the US is one of the countries that does dip into negative growth.   If that’s the case what happens to FX?  Some say the USD appreciates due to flight to safety flows, while others feel that if the US is at the epicenter of the slowdown, there will be an exodus from the greenback.  I fall into the second camp, but only time will tell.

Author: John Glover