Article

The bond market worries about a downturn

A signal has been given in the bond market that could be a sign of recession. Here’s why we think that a downturn is unlikely.

| 7 min read

Growth prospects are being reduced as Covid-19 revives in Asia and as the US Federal Reserve turns more hawkish on interest rates and cutting back on its bond portfolio.

As we entered 2022 most official and market forecasters assumed this would be a year of decent growth worldwide. The world economy would learn to live with Covid, whilst the continuing easy-money policies pursued last year by the Fed, the European Central Bank (ECB) and the Bank of Japan would allow activity to rise.

It was expected that the People’s Bank of China would be a bit tougher, but it would seek to avoid a collapse in asset prices or a slump in activity. Many expected 5% growth in China after the 8.1% recorded in 2021 when the economy recovered from extensive lockdowns. The Euro-area anticipated 4.3% growth, which has now been scaled back to 4% following a good recovery year last year. The US was expected to grow at 4% after the fast growth achieved in 2021. Japan would pick up a bit of pace after a disappointing 2021 with two down quarters separated by two up quarters that delivered little growth overall.

All change

The energy crunch then intensified, with rapid upwards pressure on oil and gas prices. Parts of Asia went back into lockdowns as Coronavirus infections soared. This was made worse by the Russian invasion of Ukraine and Western countries’ decision to start to shift their buying of oil and gas away from dependence on Russia. These additional price rises surged through the global system as a result.

General inflation was already climbing in the main advanced countries – and was given a further push by the movements up in energy and by food prices responding to likely supply interruptions and by the lockdown of Shanghai. These forces will tend to slow the economies more this year than planned or originally forecast.

China may only manage 4% growth. The Euro area will need to revise their growth forecast down substantially as its Economy Commissioner Paolo Gentiloni has now indicated. Japan is still struggling with the impact of the pandemic on the wider region but should manage a little more growth than last year. The US is still performing well on the back of the Biden budget stimulus. Fed action also increased dollars in circulation and the central bank was buying bonds up to March of this year. Whilst the economy will slow from here it is unlikely to turn negative for the year as a whole.

So, why does the bond market signal a recession?

A warning sign has appeared in markets. The two-year interest rate moved above the 10-year interest rate on US government bonds. This signal does not always mean a recession is inevitable or it may take many months before output falls that much. It implies the markets think the Fed is going to get a lot tougher soon, taking the pressure off longer-term rates as inflation will, in due course, come under control whilst frightening the short end of the market with the thought of several more interest rate rises to come.

There are ways that we could end up in recession over the next couple of years that we need to consider. It is possible the Fed, the ECB and other central banks take too tough a stance to control prices – after getting behind events with too lax a policy last year. It would be possible for them to raise rates too high for too long, hitting the price and availability of credit and cutting demand from companies and individuals for loans. It would also force governments to be more careful about new loans as they too would face debt service and refinancing pressures. This seems unlikely given the need for these central banks to keep some balance between inflation and output and, given their stance in recent years, geared to prop up output where possible.

The Fed is the most at danger of doing too much too late.

The Fed is the most at danger of doing too much too late as the US is stung by the current high inflation and the Fed is defensive over past policy. The ECB will be nervous about raising rates at all, given the exposure of Italy and other states to high debt levels. Japan will carry on with a very easy money policy as it still has no serious inflation problem. The Chinese central bank will wish to avoid excessive tightening and will keep money growth at the rate of growth in nominal GDP. This should be enough to avoid a recession. The latest plunge in sentiment reflects temporary lockdowns, though it will need watching by the authorities who will not want negative output this year.

Another way parts of the world could limp into recession would be if consumers hit by high inflation and low in confidence for a variety of reasons bought too little for a couple of quarters. Japan got close to this happening last year with two down quarters, made worse by covid lockdowns. The Euro area could be dragged down by the shock of high inflation as high energy and food prices sap people’s ability to buy discretionary goods and services.

Japan this year unlike the other main economies will have firepower to expand monetary and fiscal policy as need arises, so should be able to stave off recession. The US this year still seems to have plenty of momentum going into the second quarter, leaving scope to slow a lot without stalling. The first weaknesses will be seen in the housing market where higher mortgage rates will cut demand. New car markets remain disrupted by component supply shortages and by changes of technology for vehicles.

West leans on vaccines

Covid lockdowns can, as we know, cause sharp downturns with little notice. It looks as if Europe and America are content that vaccines can take the strain, avoiding the need for the reintroduction of long and comprehensive lockdowns. The Asians, led by China and Japan, could still need some local lockdowns given the less comprehensive state of effective vaccination and given the greater caution towards the disease shown in Asia generally.

Overall, it seems likely 2022 will be a year of downwards revisions to GDP and slowing output generally. The odd individual country could fall into a recession for a couple of quarters, but the US and the world as a whole should avoid this. It will require success in bringing inflation down by later this year to ensure the central banks can back off from further tightening in good time to protect output in 2023. We will be watching this closely in the hope that the central banks will, this time, prove the bond markets wrong and will tighten enough but not too much.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

The bond market worries about a downturn

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