Here’s why you can’t trust market signals any more
The US ‘yield curve’ is the latest market indicator whose accuracy and reliability are being seriously questioned
Every now and again, international investors become fixated on a topical theme in financial markets.
Over the past several weeks, the flattening of the so-called “yield curve” for United States government debt has become a focal point of market analysis and commentary. The yield curve – the line that plots the yields on bonds of various maturities – has been under increasing scrutiny since November 21 when the spread, or gap, between yields on 2- and 30-year Treasury bonds fell below 1 per cent, or 100 basis points, for the first time in 10 years.
A flattening yield curve is a source of anxiety because it has often been a harbinger of a recession. While the yield on the interest rate-sensitive 2-year Treasury bond has shot up a further 40 basis points since early March as the Federal Reserve has stuck to its plan to raise rates four more times by the end of next year, its 10-year equivalent has fallen 25 basis points to 2.3 per cent – 70 basis points lower than at the end of 2013 – partly because of subdued inflation. A number of investment banks, including Morgan Stanley, are predicting a “completely flat”, and possibly even an inverted, yield curve next year.
Yet just because the yield curve is flattening does not mean the US is about to suffer a severe economic downturn. In its latest set of forecasts published on Tuesday, the Organisation for Economic Cooperation and Development expects the US economy to expand 2.5 per cent next year, up from 2.2 per cent this year. Meanwhile, consumer confidence in November rose to a fresh 17-year high.
The sharp moves in bond markets this year reflect a variety of factors. These include low inflation, a significant reduction in what markets believe is the “neutral” long-term interest rate consistent with stable growth and inflation and, more worryingly, complacency among investors who may be underpricing the scope for a further tightening of US monetary policy.
The only thing that is certain is that the yield curve is the latest market signal whose accuracy and reliability are being seriously questioned.
Several other market indicators have become poor barometers of future trends.
The VIX Index, Wall Street’s so-called “fear gauge” which measures the anticipated volatility in the benchmark S&P 500 equity index, currently stands just a whisker above its lowest level since the index was established in 1990. The Vix has not risen above its long-term average of 20 in over a year despite a plethora of risks and vulnerabilities in markets, ranging from a further escalation in tensions on the Korean peninsula to mounting concern about stretched valuations in bond and equity markets.
Even the more revealing SKEW Index, which tracks how much “tail-risk” protection investors are willing to purchase to hedge against a sizeable correction in the S&P 500, has fallen 17 per cent over the past month, leaving it nearly 20 per cent below its record high set in March. This is all the more troubling given the increasing nervousness in markets about lofty valuations.
Make no mistake, key market gauges have lost much of their predictive value and should be treated with extreme caution.
This reflects the scale of financial distortions created by years of ultra-loose monetary policy and exceptionally low volatility. Current asset-prices and predictors of future market conditions do not accurately reflect fundamentals and are heavily influenced by unprecedentedly low interest rates.
The most glaring example of these distortions is the negative yields on sovereign bonds in some of the most vulnerable economies. On Monday, Italy – long regarded as the weakest link in Europe’s economy because of its dangerously high public debt, huge stock of bad loans and populist politics – sold 2-year debt at a slightly negative yield of minus 0.3 per cent. According to JPMorgan, the stock of negative-yielding government debt in Italy still amounts to US$640bn – a sixth of the total in Europe.
If this does not qualify as a severe mispricing of risk, then what does?
This begs the question whether there are any market indicators that provide a more accurate assessment of risk.
Probably not – but investors would be well advised to keep a close eye on US inflation. A sharper-than-expected rise in consumer prices would spark fears of more aggressive increases in interest rates, unsettling bond markets and fuelling a rally in the dollar.
A further tightening of US monetary policy would at least go some way towards reducing market distortions – provided, that is, that the Fed does not get cold feet if investors run for the hills.
Nicholas Spiro is a partner at Lauressa Advisory