Low bond yields do not portend recession

Serious Money: Of the many cliches that are used when describing financial markets, none is older than the one that suggests bond yields have predicted seven out of the last two recessions.

Bond markets are important, not least because most other financial assets are priced off them. Bonds sometimes appear to be the dullest investment class of all when, in fact, there is nothing more important than a bond yield. But the significance of bonds goes much further than as a benchmark for other assets. There is something called the yield curve, a piece of jargon used to describe the difference between short- and long-term interest rates.

Short rates are those set by central banks: the European Central Bank recently raised its short rate to 2.25 per cent and looks set to hike it by at least another 1 per cent over the next year or so - perhaps by even more if the European economy has the temerity to start growing again.

Long-term rates are mostly set by markets: companies and governments are the largest players. Anyone who "fixes" their mortgage - rather than borrowing at the usual variable rate - is affected by long-term interest rates.

Long-term rates are usually higher than their short-term counterparts: normally, the yield curve has a positive slope. Even if short-term rates are not expected to change, long rates will be higher, reflecting uncertainties about all sorts of things but mostly about inflation risks.

If the market expects central banks to raise rates in the future, long rates will rise to reflect this, and vice versa. Investors expect rates to rise when economic growth is booming, leading to forecasts of higher inflation.

Central banks react to such forecasts with alarm and raise rates to head off inflation. The ECB panics at the earliest opportunity and interest rate expectations are rising with each piece of economic data that suggests anything other than recession.

A significant event for bond market types is when the yield curve inverts: when long rates fall below short rates. This usually happens when investors think that the economy is in trouble and that central banks will react by cutting short rates. Hence, the yield curve is often described as a useful predictor of future economic activity. When the yield curve inverts, this is often taken as a sign of impending recession.

Historically, most recessions have been preceded by an inversion of the yield curve. The trouble is that bond markets over-predict recessions: there have been more yield curve inversions than economic downturns.

But when the bond market gets it right, the message to investors is clear and unambiguous: get out of equities. If you have to be invested in stocks at all, own "defensive" companies like food producers and pharmaceuticals.

The big financial event of the past couple of weeks was a brief inversion of the US yield curve. For a very short space of time, 10-year rates fell below their two-year counterparts. This caused a lot of excitement among commentators, with some suggesting that 2006 would see a US slowdown or even recession. The equity markets sold off on the news, although not dramatically so. If a negative message for stocks is being sent by the curve, investors are not listening very hard.

Anyone who thought the "sudden" inversion was big news must have been asleep for the past two years. The US yield curve has been moving in this direction since mid-2003. And economic growth has, if anything, been accelerating during this period.

Is the market right to ignore all of this? If the US economy is heading for trouble, the rest of the world will inevitably be affected and the strong performance from global equities seen over the past three years will be abruptly terminated.

The explanation for falling bond yields - the main source of the yield curve's inversion - is complicated and controversial. Falling yields are the flip side to higher bond prices, so some analysts have described the bond market as the latest in a long series of financial bubbles. This explanation is, in fact, heard less and less these days, as bond prices stay persistently high: bubbles, particularly in bonds, surely can't last this long?

The outgoing chairman of the Federal Reserve, Alan Greenspan, famously called all this a conundrum. The incoming chairman thinks it is all down to a global saving surplus. Others think the inherent riskiness of bonds has fallen and that inflation expectations have remained well anchored in spite of soaring oil prices. Demand for long-term bonds has been boosted by pension funds and insurance companies seeking to buy assets that better match their long-term liabilities.

All of these factors have played a part. In truth, we have a list of suspects but no compelling or complete explanation. But it does look like the connection between future economic growth and the current shape of the yield curve has been broken.

Low bond yields also go a long way to explaining the global house price boom, as well as other asset prices. Analysts who point to strong economic growth and favourable demographics only capture part of the house price story in countries such as the UK and Ireland.

Humble bond yields are at least as important a driver of property values as these more conventional explanations. An obvious source of problems for house prices would be a recession. A less obvious driver would be sharply higher bond yields.

It seems that low bond yields do not portend recession. But curve inversion does leave us scrabbling for uncomfortable rationalisations that do not include an economic slowdown. There is still an element of puzzle to all of this that should make us nervous. Or at least watchful.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.