A world turned inside out: why investors are re-evaluatingthe predictive power of bonds

A world turned inside out: why investors are re-evaluatingthe predictive power of bonds
By Jennifer Hughes
Published: February 9 2006 02:00 | Last updated: February 9 2006 02:00. Copyright by the Financial Times

Just before 1pm today, eastern standard time, anxious dealers will gather on New York trading floors to determine their final bids for the most talked-about bond sale in years.

Armed with the distilled wisdom of clients, traders and strategists, they will key their bids into a secure system. Less than two minutes later, the screens will reveal how they have fared in the first 30-year US government bond issue since 2001.

But while Wall Street is eagerly anticipating the moment, economists are dreading it. The reason? Once the 30-year bond is back it will almost certainly complete the inversion of the long end of the yield curve.

That may sound like an ugly phrase of interest only to bond market technicians. But its import could scarcely be less academic: it means that the bond market appears to be betting on a recession.

Why has the yield curve - a line chart plotting the yields paid out by different Treasury bonds against the point at which they mature - been accorded such predictive power? Normally the curve slopes upwards. This makes sense as investors would be expected to require a higher yield to compensate them for the greater risk and uncertainty of investing over a longer term.

When the curve inverts, or slopes downward, however, it implies investors believe growth will slow and inflationary pressures will weaken. In other words, they believe the central bank will be forced to cut interest rates to prop up the economy. And that means they believe the economy is heading towards recession.

Exceptionally low interest rates are a global phenomenon. In Europe, low rates and demand for longer-dated paper led France to issue its first 50-year bond last year while the UK - where the entire yield curve has been inverted since October - began a programme of 50-year bonds both at fixed rates and linked to inflation. Appetite for the UK's ultra-long paper is so strong that nominal 50-year gilts currently yield just 3.8 per cent and 50-year inflation-linked notes were offered last month with a yield of just 0.46 per cent more than inflation (see right).

But the market for US government bonds is larger, more efficient and more liquid than any other securities market - hence the attention being paid internationally to today's auction and its implications for the US economy. "We're five years into an expansion, there are no more tax rebates, the consumer probably doesn't have much money left and the price of oil is a tax. This flatness is how the yield curve should look," says Robert Kessler, a global investment adviser, who subscribes to the recession theory.

History is on his side. An inversion of three-month and 10-year yields has preceded each of the last six recessions. Since the 1970s there has been only one false signal. That was in 1998 when the markets were shaken by Asian currency turmoil, Russia's default and the implosion of the Long Term Capital Management hedge fund.

Recessions tend to lag an inversion by four to five quarters, meaning any inversion implies a recession next year. Other economists, however, believe the bond market can safely be ignored. They argue that the yield curve can be explained by increasing demand for long-term investments as pension funds grow across the developed world or by a one-off secular shift in market psychology as the world's central banks at last win investors' confidence that they can control inflation.

"The joke is that the yield curve has predicted 12 of the last seven recessions," says Milton Ezrati, economist at Lord, Abbett, a US fund manager. "The benign inflation outlook and other clear pressures flattening the yield curve can go a long way to explaining its shape aside from any recession prospects." But Mr Ezrati and others who share his logic still have to explain why investors are prepared to accept such a low yield in return for lending to the heavily indebted US government.

Even Alan Greenspan, then chairman of the Federal Reserve, declared himself baffled last year. Low long-term bond yields, which have stubbornly refused to rise as the Fed has repeatedly increased short-term interest rates, were a "conundrum", he said.

After a year in which US long bonds failed to budge despite relentless monetary tightening by the Fed, that conundrum is even more challenging.

For some, there is no puzzle and an inversion still signals what it has done in the past. "I feel like Bill Murray in Groundhog Day," says David Rosenberg, North American economist at Merrill Lynch. "I remember all too well clients telling me in 2000 that it was different this time and asking how you could square the yield curve inversion with the Nasdaq over 5000."

The curve was inverted in March 2000 when the internet-fuelled boom propelled the Nasdaq stock market to its peak. At the time, the economy and the stock market seemed indomitable. But once the bubble in technology stocks burst, the economy slid into recession in 2001 as the Fed cut rates. Nasdaq investors had been wrong. The bond market had got it right.

Others argue the yield curve's behaviour can be explained by internal market factors that have little to do with the economy. Demand for long-term investment is high - something today's reintroduction of the 30-year bond is expected to confirm.

Pension fund managers are desperate for longer-dated paper. The sharp downturn in the stock market in 2000 revealed that their assets had been overvalued and failed to match the liabilities that they owed pensioners. Buying longer-dated fixed income instruments, with steady interest payments and a lump sum some way in the future, more closely mirrors pension liabilities than do stocks.

Traditionally, pension funds had invested about two-thirds in equities and only a third in bonds. That means a significant shift in this balance would have a hefty impact on the bond market as money previously devoted to stocks poured in. The US Congress is this year expected to legislate for companies to fund their pension plans more fully, increasing demand for longer-dated debt. Reforms in Europe have already led to such a surge in demand.

A second factor in explaining the conundrum is supply. In the US, supply had shrunk even before the government stopped selling new long bonds in 2001. Today's $14bn in new bonds will, in effect, be the first issuance in six years because the Treasury's strategy of buying back its outstanding long-term debt outweighed issuance between 1999 and 2001. Another explanation is that the globalisation of the capital markets, with virtually unrestrained flow of money around the world, has boosted demand for Treasuries as highly liquid instruments.

"No firm or economist totally understands this financial interplay of the early 21st century," says Bill Gross, managing director of Pimco, the world's biggest bond manager, last week in his monthly investment outlook. "It's not that academic theory has been dislodged in recent years but it may be asked to take a seat next to the increasingly important variable of global financial flows."

Foreigners now hold 55 per cent of US government debt, and half of that is held by official institutions. Foremost among them are Asian central banks, which have made big purchases of Treasuries, swelling their reserves to record levels. The move has been driven by their policy of buying dollars to manage exchange rates and investing the proceeds in US Treasury bonds.

But despite that imperative, China, at least, has signalled its desire to secure better returns from its reserves and to diversify its holdings. Stephen Jen, global head of currency research at Morgan Stanley, says the strange behaviour of US bonds needs instead to be understood in the wider context of a "dollar zone" composed of Asian economies determined to keep their currencies linked to the dollar.

"The Fed funds rate is the rate that the Fed sets for the US economy but the US long bond rate is the rate for the whole de facto dollar zone," he says.

"Globalisation has had a huge impact on Asia's real economy but minimal effects on its weak financial sector. This has forced capital to be repelled from Asia into developed bond markets - effectively, the US acts as a 'bank' for the de facto dollar zone."

Those who claim to have cracked Mr Greenspan's conundrum can also point to a sudden proliferation of inverted yield curves elsewhere in the world. Besides the UK inversion, curves are virtually flat in Australia and Canada, and the trend on view in the US can also been seen in many eurozone countries. None of them is thought to be facing imminent recession.

Could the answer to the Greenspan conundrum lie in the man himself? Some argue that, by establishing successful inflation-fighting records and at the same time improving communication, central banks such as the Fed have ensured that markets no longer need to price in as much risk as they once did.

Data suggest that the stagflation of the 1970s scarred investors for a generation. Those scars now appear to be healing. Ten-year yields averaged 10.6 per cent in the 1980s, slipping to an average of 6.7 per cent in the 1990s as the Fed established credibility. So far in this decade, 10-year yields have averaged just 4.7 per cent.

"What the bond market has done is revert to the ranges of the 1950s and a chunk of the 1960s when inflation expectations were tame. We have unwound the excessively high real yields or inflation protection, that investors were demanding through the 1980s and into the 1990s," says Mr Rosenberg.

With yields at this level, why is it that more governments are not choosing to borrow for the long term as the US, the UK and other European countries have done? The answer is that few have borrowing needs of a scale that will allow them to issue long-term debt without affecting the market for their existing debt and potentially denting their reputation among lenders.

Perhaps credibility is the key to the conundrum. As Mr Ezrati puts it: "Confidence creates the investment community's demand for bonds. If they were to lose that confidence, then no amount of buying from official sources like Asian central banks could flatten that curve."