The Bond Market Is Giving Ominous Warnings About the Global Economy

You know the moment in a horror movie when the characters are going about their business and nothing bad has happened to them yet, but there seem to be ominous signs everywhere that only you, the viewer, notice?

That’s what watching global financial markets the last couple of weeks has felt like.

In a lot of ways, nothing looks particularly wrong. The S&P 500 was down 0.7 percent Wednesday, tumbling for a second consecutive session, but over all is down only about 5.5 percent from its early May high. The unemployment rate is at a five-decade low. With major companies nearly done releasing their first-quarter results, 76 percent had results above expectations.

But along the way, global bond prices have soared, driving interest rates down sharply. Ten-year Treasury bonds are yielding only 2.26 percent as of Wednesday’s market close, down nearly a full percentage point since November 2018. The outlook for inflation in the years ahead is falling as well, as are the prices of oil and other commodities.

Most significant, the fall in longer-term bond yields has not been matched by a fall in shorter-term rates. For example, a 30-day Treasury bill is yielding 2.35 percent — meaning you can earn more on your money tying it up for a month risk-free than you can tying it up for a full decade.

But what has happened in the last few weeks involves the specter of a longer, more painful form of damage. There have been signs that the world’s two largest economies might not simply be experiencing some tensions and trading a few tariffs, but could be heading toward a broader split.

In a sense, economists may have been analyzing the trade war too narrowly, merely by calculating the cost of tariffs and where those costs may show up.

The potential long-lasting consequences are harder to model.

What if American regulators try to cut off Chinese companies’ access to Wall Street and its vast pool of financing, as some China hawks are advocating? What if China cuts off exports of the rare earths materials that are crucial to advanced manufacturing in the United States? Will the Trump administration’s ban of the technology giant Huawei be the first step toward a bifurcation of today’s global internet into American and Chinese spheres?

Or it could even be this simple: If there is a slowdown in the Chinese economy that causes its demand for oil and other commodities to fall, American makers of those commodities could face pain over and above that caused by tariffs directly. Falling global commodity prices would pull the world economy even further into its deflationary rut.

That last story is particularly consistent with the swings in markets this month. Because tariffs tend to increase consumer prices, you might expect the escalating trade war to cause investors’ expectations for inflation to rise.

Yet the gap in prices between bonds that are indexed to inflation and those that are not suggests that investors envision annual inflation of 1.6 percent over the next five years, down from 1.8 percent at the start of May.

There are further signs of trouble from around the world: threats of conflict with Iran, missile tests in North Korea. European politics is a mess.

It can be a mistake to assume that financial markets are responding to the latest geopolitical headlines. But put it all together, and there’s less of a mystery about why bond investors are in a more pessimistic mood than the recent economic and earnings data might suggest makes sense.

It is premature to assume that a recession or a geopolitical crisis is imminent. U.S.-China relations could enter another period of détente, the Federal Reserve could take a precautionary interest rate cut, and the economy and markets could once again be off to the races.

In other words, we don’t know yet if this is a horror movie or a comedy, but in the months ahead it seems we’ll find out.

Source link Business

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