The world-renowned bond guru Bill Gross sees the currently tightened central bank policy of the US as a threat to the largest economy in the world. Is there an economic collapse?
According to the latest investment outlook from Janus Henderson Investors of July 2017 – in which Bill Gross is bidding his thoughts on international markets a month – the investment manager warns of a possible recession in the USA. According to Gross, the US Fed’s rate hikes could drive yields to a level that leads to a flat or even an inverted interest rate structure. A flat interest rate structure comes when short-term yields – often measured by the three-month treasury bills – are closely related to long-term yields, as measured by the ten-year treasury bonds.
This means that the return on long-term and short-term government bonds is roughly the same, or there is only a very small yield gap between the two returns. In the case of an inverse interest rate structure, short-term government bonds even yield under long-term government bonds. Although this constellation is absurd on the basis of returns / risk considerations, the empiricism shows a number of example phases. An inversion of the yield curve would be the possible death kiss for the current economic recovery from a historical perspective. However, it might be the case before – but more on that later.
Inverse interest structure as a bad omen
In the last 25 years, a recession has occurred in the US whenever the interest rate structure has been inversely inverted. Thus, the last three recessions in 1990, 2001 and 2007-2009 have been projected correctly by an inverse of the yield curve. The possible mechanism behind this: In the economic upturn, the central bank often exaggerates its interest rate hikes, which makes yields rise at the short end.
However, as many market participants, after years of prosperity, again see a close economic upturn and are leaving the stock market and shifting their money into long-term government bonds, the increased demand for long-term government bonds drops yields at the long end. The result may be an inversion, which is rather rare and untypical in the markets, since the more time you spend your money on interest rate papers, the more money you spend, the better. However, if inversion occurs, this has been an evil omen for the economy at least in the last decades.
Despite the quarrels surrounding the current US President Trump, the US economy is currently doing well. Unemployment is as low as long, and ISM’s purchasing managers’ index as a highly respected economic indicator signals growth. In addition, consumer confidence is at a high level and shows that US consumers are positive.
As consumption in the US accounts for about two-thirds of the economic power, a high level of consumer confidence can only be good. But beware: In the past, positive extreme values for important US economic indicators and low unemployment rates have often coincided with the start of economic downturns. Actually, as every boom of the bust follows, the bear market must be born at the end of the boom.
As far as interest rate structure is concerned, no inversion has yet to be established. The emphasis is “not yet”. It is a matter of how often and how much the bank is still working on the interest rate. Nevertheless, Gross notes in the current market situation that short-term interest rates do not necessarily have to rise to or above the yield level of long-term interest rates in order to trigger a recession. Even a flatter interest rate structure than now could signal an economic downturn.
The central bank should therefore be careful not to exaggerate its interest rate hikes. Due to the high debt – from young students, private households to companies – higher interest rates could be a risk, according to Gross. Here is currently no inversion to be determined. The emphasis is “not yet”. It is a matter of how often and how much the banknote still turns on the interest rate.