The bond market is trying to tell you things. Even if you don’t own any bonds, you should pay attention to what it is saying.
The market’s clearest message is that the global economy is slowing. A recession is still far from a done deal. However, a significant downturn is becoming a distinct possibility.
The evidence for this? Bond yields have tumbled across most of the developed world over the past three months. They have fallen in Canada and the United States They have also declined in countries such as Germany, France, the Netherlands, Switzerland, Sweden and Japan where payouts on five-year government bonds were already near or below zero.
The falling yields make sense if you believe the global outlook is dimming. As risk grows, investors are willing to put up with lower, or even negative, payouts on bonds because of their desire to find a relatively safe place to stow their wealth.
To be sure, the current clouds could dissipate. Maybe the outlook is brighter than the pessimists think. Recent data on Canadian and U.S. jobs have actually been rather encouraging. But it’s difficult to ignore the possibility the doomsayers are right, especially in the case of China and Europe, where economic readings in recent weeks have offered a steady drizzle of disappointment.
If global growth does slide, bonds will be a more attractive investment than today’s paltry yields would suggest. Bond prices move in the opposite direction to yields. So a weakening economy that prompts a further downward move in yields would constitute good news for at least some bond investors.
“We think the darkening prospects for the global economy favour high-grade bonds over equities this year,” wrote John Higgins of Capital Economics in a recent report.
In his view, both the Chinese and euro zone economies are losing momentum while the U.S. economy is headed for a sharp slowdown. This is not an environment in which stocks will prosper.
Neither is it a wonderful climate for bonds in riskier economies. If global prosperity hits a bump, investors are likely to play it safe by retreating from bonds in emerging markets. They are also likely to ditch bonds from developed countries such as Italy that are facing political turmoil.
However, a widespread slowdown would provide a boost to investors who hold investment-grade bonds in relatively stable countries, such as the United States and Canada, where rates are not already ultra-low. If a global slowdown means lower rates in North America, these investors will reap profits as their bonds rise in value. The gains would be particularly large if a U.S. or Canadian recession materializes.
How likely is that to happen? The recession probability index maintained by the Federal Reserve Bank of New York uses yields on government bonds to assess the chance of a significant slide in the economy. The index has risen in recent months and now pegs the odds of a U.S. recession over the next 12 months at 23.6 per cent, the highest level since the financial crisis.
Another indicator, the excess bond premium, measures the degree of risk appetite among bond investors and uses signs of increased caution to spot potential trouble ahead. It recently signalled a 19.5-per-cent chance of a U.S. recession over the year ahead.
Yet another bond-related indicator, the yield curve, measures how short-term bond yields compare with longer-term yields. It, too, is registering concern, although it has calmed down a bit from December.
Back then, the most widely followed version of the yield curve was on the verge of inverting – a condition in which normal patterns flip and short-term yields move higher than long-term yields. Stock markets fell as an inversion grew closer because a yield-curve inversion has historically been one of the most reliable warning signs of a U.S. recession to come. But the curve stopped just short of inverting and has remained relatively stable in recent weeks.
According to this gauge, bond investors do not think a recession is certain. But falling yields and a nearly flat yield curve indicate a high level of worry about the fading outlook for global growth. In such an environment, investors should remember that bonds have their merits. If Mr. Higgins is right, they could give stocks a run for their money over the months ahead.
Ian McGugan