Treasury Yield Curve: Not all is doom and gloom

Major banks may warn of slowdown, but indicator suggests alarms premature

LAHORE:

Major banks are predicting a global economic downturn. But should we take them seriously? This is one of the oldest questions in finance. Like any worthwhile question, it is contentious. Two schools of thought- call them the “psychological schools”- say yes, while one “formal” school says no.

Enter the dramatis personae

As early as June 2015, the Bank of International Settlements warned in its Annual Report of “malaise in the global economy [where] the economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited.”



In September 2015, Citibank chimed in with its Global Economics View: “We believe that there is a high and rising likelihood of a Chinese, Emerging Markets and global recession scenario playing out.” Also in September, J.P. Morgan’s Eye on the Market bulletin warned institutional investors of “a 2% growth world [where] markets are vulnerable to corrections, and have difficulty sustaining lofty valuations.”

Royal Bank of Scotland rang in 2016 with the darkest portents of all. “Watch out. Sell (mostly) everything,” shrieked RBS’s European Rates Weekly of January 8.

And what followed was a masterpiece of apocalyptic prose: “the world is slowing, trade is slowing, credit is slowing, we are in a currency war, global disinflation is turning to global deflation as China finally realises what it needs to do (devalue soon, and sharp) and the US then, against ALL THIS countervailing pressure, then stokes the fire by hiking rates.” Between the upper case letters, questionable grammar, and refrain of all things “slowing,” the RBS memo elevated financial advice to the level of epic tragedy.

Economic doom drawing close? 

Banks seem to agree that a catastrophe is around the corner, but they are not sure why. So what is going on? The three schools I mentioned earlier- two psychological and one formal- offer different perspectives.



The two psychological schools are Keynes and Soros. Keynes famously likened the financial markets to a beauty contest: suppose that newspaper readers were asked to pick the most attractive faces from a picture gallery, and those who picked the most popular faces won a prize. The task for the readers, then, would not be to determine who was most beautiful, but to determine whom others would find most beautiful.

In the stock markets context, the Keynesian investor is not interested in what he thinks will happen, but in what other investors think.

On this view, the banks’ advice may indicate to us that institutional investors are likely to sell equities in the near future. Since institutional investors have the largest effects on the equity markets, we ought to take the bank warnings seriously.

The second psychological school uses George Soros’s “reflexivity theory.” On this view, market sentiments are self-reinforcing: they oscillate between booms and busts rather than move toward equilibrium prices.

Once an equity price starts to fall, investors begin to sell, expecting the price to fall further. This selling precipitates a further fall, and the equity markets continue to decline. Expectations are reversed when the market bottoms out, but as equity prices rise, investors expect them to rise further and begin buying: the price rise is also a self-fulfilling prophecy. Reflexivity suggests that the recent slow-downs noted by the banks are likely to continue because they are self-reinforcing prophecies.

Treasury Yield Curve

The Fed School offers the best leading indicator for a global recession:  the Treasury Yield Curve. If you take nothing else from this article, take an appreciation of this indicator for recessions. The Curve shows the spread between the yields on long-term (10-year) treasury bonds and short-term (three-month) treasury bills.

In general, the yields on long-term bonds are greater than those on short-term bills: investors expect a premium for locking in their money for a longer period. However, when the market expects a recession, short-term interest rates exceed long-term rates.



This is because before a downturn, investors expect the short-term yields to plummet (when the Fed cuts interest rates), and therefore switch to long-term bonds. As the demand for long-term bonds increases, their yield relative to short-term bills declines.

We should keep an eye on the Yield Curve. For now, it suggests that long-term interest rates are comfortably above short-term rates, so that a US contraction is unlikely. This is only a partial comfort to investors in Pakistan.

The treasury yield curve only incorporates the sentiments of investors who have access to US treasuries, and most of these investors may be insulated from markets such as Pakistan. However, US exposure to the global economy should still be broad enough for the yield curve to serve as an indicator for a global (if not emerging market) recession. On that evidence, at least, the alarm seems to be premature.

The writer is a professor of law and adjunct professor of business at Lums

Published in The Express Tribune, January 18^th, 2016.

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