What the yield curve reveals about the economic outlook

While declining bond yields may encourage talk of recession, conditions need to conspire a lot more aggressively against the Australian economy for that to eventuate.

Government bond yields have plummeted this year, which would normally herald a recession. Not everyone is convinced this is likely, however, with other factors at play.

Bond yields have turned negative in Japan and Germany and are at a record low for 10-year Australian Government bonds. In the US, the 10-year bond yield curve has turned inverse (2.3 per cent), and what’s spooked markets are the smoke signals this sends that recession will follow.

Without doubt, bond markets expect global economies to slow. However, Shane Oliver, chief economist at AMP Capital, suspects markets could be sending false signals. While the US yield curve may be flashing warning signs, he rejects suggestions that a recession, either in Australia or the US, is imminent.

Oliver says investors have moved into bonds in response to the 2018 stock market fall, raising prices and pushing yields lower.

False signals on interest rates

There are other factors pushing US interest rates lower, which Oliver doubts are indicative of an approaching US recession. These include the Federal Reserve’s new-found dovishness – following an abrupt end to further interest rate hikes – and negative German and Japanese bond yields holding down US yields. Then there’s the realisation that central banks won’t dump their bond holdings any time soon. To do so would be a de facto tightening in monetary policy, and given low inflation and uncertainty around growth, they know all too well, adds Oliver, that it’s way too early for that.

“Wages growth is still moderate, inflation is benign, there has been no boom in consumer spending, investment or housing construction, and private debt growth overall has been modest,” says Oliver.

“It may also be argued that President Trump will do whatever he can to avoid recession next year as US presidents don’t get re-elected when unemployment is rising.”

Low inflation, low interest rates

CommSec chief economist Craig James says other structural factors, including the anchoring of both low inflation and interest rates expectations, with globalisation maintaining inflation at low levels, are keeping yields low.

“The yield curve is telling us that inflation is contained, and with inflation contained and economic growth not expected to accelerate markedly, interest rates are set to remain low.”

Nevertheless, what concerns Stephen Anthony, chief economist with Industry Super Australia, are growing indications that the Australian yield curve is sending similar signals to those overseas, where bond markets – a leading indicator of volatility on capital markets – are now flashing red.

Anthony says that growing macroeconomic headwinds – including any weakening Chinese demand for resources, a residential property downturn, ongoing trade wars, Brexit, Italian fiscal issues, and the remote possibility of another Middle East war – only fuel economic uncertainty.

However, while declining bond yields may encourage talk of recession, he says conditions need to conspire a lot more aggressively against the Australian economy for that to eventuate.

Inversion doesn’t spell recession

While Oliver advocates treating the yield curve with respect, he notes that curve inversions (where longer-term bonds trade at a lower yield than bonds with a shorter maturity date) don’t necessarily result in recessions, and the link between yield curve inversion and recession is even less predictable. For example, on the occasions when it previously inverted against the cash rate (2008, 2011/2012) in the last 20 years, the Australian economy has not gone into recession.

Even if Australia’s yield curve did become inverted, Oliver says recession may not occur until mid-2020. In the US, where recession has appeared more likely, it has taken time to materialise. For example, the US economy did not fall into recession until about two and a half years after US 10-year Treasury note yields first fell below two-year note yields in mid-1998.

The real bond inflection point

Any economic downturn is less likely to come from bond yields than a notable uptick in unemployment, says Anthony. Once unemployment rises from 5.2 per cent to beyond 5.5 per cent, he expects increasing talk of a recession as a probability.

The Reserve Bank of Australia (RBA) is now paying more attention to labour market indicators, and with inflation set to remain low, is turning its attention to what else needs fixing, says James. For example, he expects further RBA commentary to highlight where both the government and regulators can do more to boost productivity in order to lift the growth threshold for the country.

“The RBA is also trying to get its head around globalisation and the ‘gig’ economy, and access to finance, plus the cost of finance, are other areas where it can work with regulators.”

While the Australian economy can conceivably slow down more and unemployment could hit 5.5 per cent without tipping the economy over, Oliver says talk of recession would jump significantly should unemployment cycle up beyond 6.3 per cent.

Additional RBA rate cut measures may provide some relief. However, Oliver says it is tax reform, and infrastructure spending on high value projects, that will give the economy its biggest stimulus. “We also encourage the government to undertake more green-fields infrastructure spending models similar to those successfully deployed in New South Wales and Victoria.”

Read next: Interest rates Australia: the outlook for 2019

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