The financial media tend to report breathlessly about what the stock market did yesterday. But savvy economic analysts have always known the bond market is the place to look for a real sense of where the economy is going, or at least where the smart money thinks it is going. And right now, if the bond market is correctly predicting the economic path ahead, we should all be terrified.
But, please, read on before panicking. There’s a lot more to the story.
The stock market can rise and fall for all sorts of reasons, and sometimes for no apparent reason at all. But the bond market, where trillions of dollars change hands and long-term interest rates are determined, is steadier (normally). Its prices are generally tied closely to the outlook for growth and inflation over the years ahead.
The long-term interest rates that currently prevail across all the major advanced economies are consistent with a disastrous economic future. Taken at face value, they imply that the smart money expects inflation will remain extraordinarily low for years to come, and that growth will stay so weak that central banks won’t be able to raise rates for years. It is a shift that has accelerated since Britain’s vote on June 23 to leave the European Union, but one that has been underway for years.
Look at the current shape of the American “yield curve,” the chart of how rates compare for short, medium and long-term bonds. It implies a 60 percent chance of a recession in the next year based on historical patterns, according to Deutsche Bank analysts. Long-term interest rates hit record lows last week — which is to say the lowest in the 227-year history of rates in the United States.
Prices for inflation-protected bonds suggest that consumer prices will rise only about 1.4 percent a year through 2021 — and only 1.5 percent in the five years after that. They suggest that not only is the Federal Reserve unlikely to find conditions that warrant an interest rate increase in the remainder of 2016, but also that there is only about a 50 percent chance of a rate increase in 2017.
Across other major advanced economies, the signals sent by bond prices are even worse. Ten-year bonds are now offering negative interest rates in Germany, Japan, Switzerland, Denmark and, as of Friday’s close, the Netherlands. That means buyers of these securities will get fewer euros, yen, Swiss francs or Danish kroner back than they invested, a development without precedent in hundreds of years of financial history.
But that phrase “taken at face value” is doing some heavy lifting here. There are reasons to think that current prices are reflecting idiosyncrasies in the supply and demand for safe assets, rather than a conviction among global investors that very bad times are ahead.