World Economy

US Bond Traders Led Astray

US Bond Traders Led AstrayUS Bond Traders Led Astray

Figuring out whether the US economy was headed for trouble used to be easy: all you had to do was look at the bond market. But not anymore.

Now, that same market has become so distorted by years of near-zero interest rates that Wall Street’s biggest bond dealers are drawing wildly different conclusions as they try to come up with alternatives, Bloomberg reported.

Bank of America Corp.’s model suggests the gap between short- and long-term treasury yields—which has predicted every recession in the past half-century—should already be inverted and puts the chance of a downturn at 64% in the next year. Barclays Plc and TD Securities have tossed out the so-called yield curve altogether. The former says its model shows the risk of recession at 20%; the latter, about 50%.

As turmoil in financial markets deepens and confidence in central banks’ ability to support the global economy ebbs, the stakes could hardly be higher. For investors, the big worry is they’ll end up flying blind when the next recession hits. And as more and more question the models they’ve counted on for decades—at a time when panic is seeping into the markets—volatility roiling bonds, stocks, currencies and commodities may only get worse.

“We truly are in new territory,” said Mark MacQueen, the co-founder of Sage Advisory Services Ltd., which oversees $12 billion from Austin, Texas. “Looking back at the history of the yield curve and comparing it to today, is dangerous.”

 Economy at Risk

Normally, when longer-term yields are higher than shorter-term yields, it suggests investors see growth in the economy, and as a result, demand extra compensation for the risk that inflation will erode the value of their fixed-rate payments over time.

When that relationship flips (resulting in what’s known as an inverted yield curve), it’s usually a sign the economy is at risk of contracting. That’s happened before each of the past seven recessions dating back to 1970, data compiled by Bloomberg show. On average, downturns start less than a year after the yield curve inverts.

While signs of a weakening global economy have caused yields of 10-year treasuries to plummet about a half-percentage point to 1.79% since the start of the year, they still yield 1.51 percentage points more than three-month T-bills. That’s close to the five-decade average of about 1.5 percentage points and well above levels that would typically set off alarms over the state of the US economy.

The same is true for longer-term spreads such as those on the five- and 10-year note relative to the 30-year bond, which are both greater than their historical average.