Yield curves signal possibility of a global recession

Friday, May 27, 2005

While the most recent round between the US (Treasury Secretary John Snow) and China (central bank chief Zhou Xiaochuan) on a Yuan revaluation brought just another standoff in the long-running debate, bond markets start to signal far more worrying news ahead. Over the last month only the yield on 10-year notes fell 19 basis points (bp) to 4,07 percent while the yield on 2-year notes softened only two bp to 3,62 percent, reducing the spread to only 45 bp. The spread between 2 and 3-year notes amounts to no more than 5 bp based on Thursday's closing prices. All this flattening stems to the bigger part from the rise on the short end, while the long end continues its puzzling streak that added "conundrum" to common Fed watcher's vocabulary. All US recessions were preceded by an inverse yield curve and the point this could happen is only 4 FOMC meetings away, when one presupposes the Fed will keep it's measured pace of 25-bp hikes.
European bond markets look no better. 10-year German bund yields fell 22 bp to 3.21 percent within a month while 3 to 5-year maturities softened only 16 bp to 2.52 percent, according to Bundesbank data. The picture of flattening yield curves gets repeated in most European nations and one does not need to look at a chart to see that the Japanese government bond yield curve is flat only for the reason that the short end is near zero. We know that for years already.
All these markets share one common perception: Their economies are going to slow soon, as the latest OECD report from Wednesday confirmed.
According to Morgan Stanley economist Ted Wieseman, the rush out of bonds may evolve into a stampede. "In an economy growing at a sustained 4%+ real rate, experiencing near-record low national savings, a corresponding record high current account gap and rising inflation, bubble seems the only reasonable way to describe real short rates of barely over 0%, real five-year rates of less than 1%, real 10-year rates of 1.6%, and real 20-year rates of less than 2%, probably 200 to 300 bp below sustainable fair-value levels depending on maturity," writes Wieseman.
This rush is likely to happen once consumers and investors are pressed into liquidating their long-end lending positions to cover their short-end borrowing. As said before, this may be only 4 FOMC meetings away which is as soon as November 1.
In Europe this move could take a little longer as the ECB tries to stay on autopilot as long as possible, hoping that the low leading interest rate of 2 percent will spur higher growth than the forecasted 1.2 percent at a not too distant point of time. This hope could be spoiled by an uptick of Euro inflation rates soon though. This year's recovery of the dollar and skyrocketing oil prices should show up nastily in the next inflation figures to come as dollar-priced commodities become more expensive, a fear also expressed by ECB head Jean-Claude Trichet.
Precious metals move into the picture
Currency markets will continue their battle of the two sinking ships displaying the names Euro and Dollar, it can be projected. With the meltdown on bond markets looking imminent for the reasons given above, The Prudent Investor wonders where a safe haven can be found as Switzerland just annulled its GDP growth forecast of 1.5 percent, Bloomberg reports.
As there seems to be an asset deflation just around the corner that could also hit commodities because of slowing demand caused by the economic downturn, precious metals could outshine all other asset classes. Gold looks like a steal at current prices and silver even more. Both metals are in a longterm upward trend since five and three years which coincides with the weakest economic recover ever seen in the US and slowing growth in Europe. Gold's 8 percent downturn from last year's high at 455 dollars cannot be seen as a trend reversal but rather as a healthy correction in a secular bull market. In a time where growth prospects are limited to the field of uncertainty, the 6000 year old universally accepted currencies may be rediscovered by investors despite continued central bank sales. The case for silver is made by the historically above average ratio of roughly 60:1 to gold. The average longterm relation is closer to 15:1. Gold additionally seems to be supported by the slowing of central bank sales and huge physical demand in India (600 tons p.a.) and China where gold investments were liberalized only last year. And fears of reduced industrial demand because of digital photography have been over-exaggerated, silver bulls point out. Silver is also used in numerous other industrial applications, especially electronics.
A rise in precious metals could also start the global redistribution of wealth. Reuters reported on Wednesday that developing countries accounted for 72 percent of global bullion output last year. The strongest rise in output was seen in Highly Indebted Poor Countries (HIPCs), whose gold production rose 84 percent between 1994 and 2004. Global gold mine output was 2,464 tonnes in 2004.
SPOTTED IN BLOGOSPHERE: Cynic's Delight shares my worries with more reasons.
Michael Shedlock
points to a commentary of Northern Trust (pdf) that combines gold and China in a novel way.
Mark Thoma picks up an interesting piece on Greenspan's succession, due in 250 days from today.
The Skeptical Speculator provides us with a compilation of the latest econ data.
The world 2 come has all the links regarding the EU constitution.
Mahalonobis discusses the weakest-ever employment growth in a US recovery.
Don't blame me if you spend another weekend in front of your screen.


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