What are low bond yields suggesting? Better growth.
by James Kochan, Wells Fargo Asset Management
If you believe what you see in the financial press, with the recent drop in yields, the bond market is suggesting either a slowing in gross domestic product (GDP) growth or a recession. In contrast, the stock market appears to be arguing the opposite. Which is the more likely outlook? Stock prices are included in the index of leading indicators. Bond prices are not, but the slope of the yield curve is included. Meanwhile, Deutsche Bank economists are saying that, because the yield curve is now relatively flat, there is a 60% chance of a recession in the next 12 months. Is the bond market that prescient?
I think the answer is a resounding no! The current super-low bond yields are probably due more to exceptional global factors than signs of weakness in the domestic economy. Almost all the economic indicators that have been reasonably good guides to future activity are quite healthy:
- Initial unemployment claims are very low.
- The Institute for Supply Management indexes for manufacturing and services, and their new orders components, are in growth territory.
- Housing data are improving.
- Incomes are growing.
- Consumer confidence indexes are not declining.
- The stock market is not suggesting a recession.
If we can rely on this impressive list of positive indicators, very low bond yields should be regarded as stimulative rather than cautionary. These yields have already sparked another round of mortgage refinancings that should increase household spendable income. Lower mortgage rates should also help sustain what has finally become a stronger pace of home sales and housing starts. A sharp decline in housing activity has typically preceded recessions, but housing will now very likely provide a measurable boost to growth in the quarters ahead.
Citing a flatter yield curve as a recession signal confuses correlation with causation. While yield curves have usually become flat or even inverted prior to recessions, it was the level of rates and bond yields, not the shape of the curve, that caused economic slowdowns. In past cycles, yield curves became unusually flat as short-term rates rose faster than bond yields. Recessions resulted when interest rates and bond yields rose to levels that caused borrowing and spending to weaken. Mortgage rates typically played a key role in this process—rising to levels that made buying a home less affordable. In 2007–2008, the rise in short-term rates pushed up adjustable-rate mortgage rates to levels that resulted in waves of mortgage defaults and plummeting real estate values. A relatively flat yield curve—with rates and bond yields at or near cycle lows—does not have the same implications for GDP growth as a flat curve that emerges after rates and yields have increased sharply from cycle lows.
A final thought for investors
Bond yields have been unusually low in the U.S. because relatively slow economic growth has allowed the Federal Reserve to keep the federal funds rate near zero. If low yields were a good predictor of recessions, we probably would have seen a recession by now. The latest drop in yields had its origin overseas, and negative yields abroad could keep U.S. yields low for a while longer. It does not follow, however, that those low U.S. yields are a recession signal. Indeed, these low yields are probably a precursor of better growth.
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