America’s unemployment rate is now lower than it’s been in five decades. Just three years ago, mainstream economists insisted that a labor market this tight, amid inflation this low, was an impossibility. The percentage of Americans who believe “now is a good time to find a quality job” is at 71 percent, the highest that figure has ever been in Gallup’s polling. Corporate America’s first-quarter results are (virtually) all posted, and 76 percent of major companies outperformed expectations. Donald Trump may be a historically unpopular president, but a healthy majority of voters can’t help but approve of his economic management.
But like a dour wallflower who brought his copy of The Uninhabitable Earth to a party, the typical bond investor can’t join in the sheeple’s good cheer — for he knows too much about where all this is headed.
Or so two recent trends in global bond markets would suggest. The first is that the prices of ten-year government bonds are rising across the developed world. When investors see trouble on the horizon, they move their capital out of equities and into such bonds since the governments of wealthy nations tend to pay back their debts, irrespective of medium-term economic conditions. Thus, the fact that investors have been bidding up the price of government bonds suggests that they’re feeling a bit spooked.
A related — but decidedly more alarming — development is that this frenzy in ten-year bond buying has actually pushed the yield on long-term U.S. Treasury bonds beneath the yield on short-term ones. This phenomenon is known as an “inverted yield curve,” and it is one of the most reliable indicators that the American economy is headed for a recession in the near future. The logic behind this correlation is simple. In ordinary times, investors will demand a higher yield on long-term bonds than short-term ones, since locking your money into a Treasury for a decade is riskier than doing so for just three months. After all, a bond that pays 2.5 percent interest may be appealing today, when inflation remains below 2 percent — but if prices start spiking five years from now, and the Federal Reserve drastically raises benchmark interest rates, then that bond will plummet in value.
Therefore, if investors are willing to pay a premium to tether themselves to today’s interest rates, they ostensibly believe that inflation isn’t budging for a long time, and that the Federal Reserve will actually be cutting interest rates in the near future — something that the central bank rarely does in the absence of adverse economic developments.
Now, the inversion of the yield curve isn’t an entirely new story. The yield on ten-year Treasury notes dipped below the yield on three-month ones back in March. But this inversion has deepened to an ominous degree in recent days. As Bloomberg reports:
A key slice of the Treasuries yield curve became the most inverted since 2007, as growing angst over trade friction is overshadowing expectations that the Federal Reserve will cut interest rates by year-end.
The gap between three-month and 10-year rates dipped Wednesday to negative 12.3 basis points, breaking past a March level, when it first reached levels last seen in the global financial crisis. The spreads between most other sectors of the curve have narrowed as well.
All of which raises the questions: What are bond investors so afraid of? And are their fears rational?
Most economic indicators in the United States are currently positive. But there are some exceptions. As the New York Times’ Neil Irwin notes, orders for capital goods fell 0.9 percent in April, while a major index of manufacturing activity also dropped sharply. That said, the darkest clouds on the horizon are creeping toward the U.S. from overseas.
As my colleague Josh Barro notes, the trade war between the United States and China is on the cusp of escalating to the point where the direct effects of rising tariffs could shave up to one point off of U.S. GDP. That wouldn’t necessarily be enough to tip America into recession, but it would put a damper on growth. Regardless, the direct effects of Donald Trump’s trade war almost certainly scare investors less than its broader implications.
A healthy, growing Chinese economy is a precondition for sustaining global demand, especially for commodities. And China’s economy is already in a slowdown. If the president’s tariffs depress Chinese growth further, American exporters of oil, soybeans, and other commodities could be forced to slash prices to find buyers for their products. The fact that bond investors are anticipating persistently low inflation is consistent with the idea that they’re worried about flagging Chinese growth.
But investors’ pessimism may be based on the possibility of more momentous consequences of rising U.S.–China tensions. As I recently noted, the Trump administration’s ban on Huawei — China’s largest technology company — threatens to bifurcate global telecommunications, thereby ending globalization as we’ve known it. If the return of great-power competition deprives China access to American-made semiconductors or the U.S. access to China’s rare metals or exceptionally cheap technology exports, then countless supply chains will be disrupted and economic efficiencies lost. The long-term outlook for global growth could sink durably downward.
What’s more, it isn’t hard to find causes for bearishness outside of U.S.–Sino relations. John Bolton is perpetually nudging the United States toward a disastrous war with Iran, North Korea’s latest missile tests threaten to reignite tensions with Pyongyang, and, of course, mankind is continuing to march headlong toward ecological destruction.
So, bond investors have some sound causes for anxiety. But that doesn’t necessarily mean we should accept their counsel of doom. The Federal Reserve cut interest rates preemptively — even as the expansion remains in bloom — and sent stock markets soaring once more. Trump could decide that his trade war is putting his reelection at risk and abruptly surrender. The Chinese Communist Party could once again prove itself to be global capitalism’s savior and revive rapid growth.
And even if none of those things happen, and a recession once again follows the yield curve’s inversion, it often takes one and a half to two years after an inversion for the downturn to kick in. Which means that the bad times might not come until Trump is safely reelected — or a Democrat takes the wheel. And why would anyone worry about that?
