Earthquakes are especially disconcerting when you’re sitting on the toilet. Perhaps that’s why they make them so comfortable here in Japan.
Before I’d emerged from the bathroom, the various family members across the country had already checked in with each other. A few hours’ drive away, closer to the epicentre, grandma’s family heirlooms had taken a tumble.
Japan is not the only one wobbling. Bond markets around the world are looking skittish too. And late last week we found out why.
The monthly Treasury International Capital report came out to reveal that key countries dumped US government debt in April. And at the second fastest monthly pace for more than ten years.
Russia dumped half its holdings of US Treasury debt. Japan’s holdings trended to its lowest since 2011. Intermediary countries like Ireland and Luxembourg reported tumbles too. China’s didn’t change much though.
The explanation for this selloff is that nations need US dollars to fight trade wars, so they’re selling their US dollar assets. Or perhaps they’re just retaliating against Donald Trump where it hurts.
The result of the selloff was a spike in US government bond yields. Above 3% on the 10-year bond. This was the line in the sand for a long list of pundits who predicted it would lead to trouble.
It’s not just the US bond market. There was also the Italian bond market chaos of May. And crises in Turkey and Argentina too.
Are all these spikes connected? We’re looking into how countries that issued US dollar debt might be impacted by the higher rates in the US. More on that soon.
Today, consider the moves in interest rates have had an interesting effect.
The global bond yield curve has inverted
It’s an obscure statement, I know. But it might just be the most telling indicator that an economic slowdown is around the corner.
The last time the global bond yield curve inverted was the end of 2007. Before that, during the emerging market debt crises of the late 1990s and the tech bubble.
But what is the global bond market yield curve inversion?
The yield curve tells you how much interest the government has to pay to borrow for various different time periods. Say it costs 3% to borrow for one year, 4% for five years and 5% for ten years. Connect the dots on a chart and you get the yield curve.
Normally this curve is upward sloping. The longer the time period of borrowing, the higher the interest rate. The threat of rising inflation, default and other factors all grow as you increase the time of borrowing, so investors demand higher returns for lending to the government.
When a yield curve inverts, it is downward sloping. It’s a sign that something is seriously wrong in the short term.
Usually, only a small section of the curve inverts. So, for example, the government might have to pay more to borrow for three years than one year or 30 years. This suggests there will be a recession in the next 2-3 years. That’s because investors are requiring a premium to invest for 2-3 years given the risk of a recession during that time.
As an aside, this doesn’t make much sense to me. People tend to buy bonds and bid them up during a recession. They’re safer, offer fixed returns and interest rate cuts at the central bank tend to bid them up. If the recession is only going to last for a short time, then you’d buy short-dated bonds especially, as people flock to their safety. Both factors should drive short-term bond yields down, not up, in anticipation of a recession. That’s precisely the opposite of conventional wisdom though.
And there’s no denying conventional wisdom has it right in practice. The power of inverted yield curves to predict recessions is excellent.
Well, for the first time since 2007, the global yield curve has inverted. Governments around the world are having to pay more to borrow for 1-3 years than 7-10 years according to a JP Morgan calculation.
It’s mostly because the US government dominates the curve at the short end. And US interest rates are higher than in Japan and Europe. So the particular global yield curve from JP Morgan is a little skewed.
But the point remains. There is a serious imbalance in interest rates around the world. And it’s signalling the potential for a recession.
Avoiding theoretical wealth
Does it ever seem odd to you that so much of our wealth is nothing but a claim on someone else?
Shares are a claim on a company’s profits. Bonds are a claim on someone else’s assets. Bank accounts are a claim on the bank. Even our pensions are a claim on an institution and government system.
Very few mainstream investments are an asset that is not a claim on someone else.
This is why financial analysts often speak about trust. During times of high trust, the risk of this system of claims seems small. The idea that someone else won’t pay up is distant.
But when trust breaks down, it’s as if a whole new type of risk enters your calculations. That makes investments worth less – you’re not willing to buy something if you don’t know whether the claim will be upheld.
In a time like this, what investments do you want to hold? Which assets are least reliant on trust for their value?
The discussion above about wobbly bond markets suggests now is the right time to ask this question.
Bonds are the asset most reliant on trust. They are long-term investments and promise a fixed return. The lack of upside risk means the key question determining their value is default risk in the form of inflation or an actual default. The focus on the downside risk makes holding bonds a bet on trust continuing to flow through the global financial system.
If bond markets like Italy and the US are wobbling, it’s time to reassess your portfolio. Are you adequately invested in real wealth that does not rely on trust?
It doesn’t have to be precious metals, by the way. Other commodities and energy can be excellent hedges against a breakdown of trust. Because they’re real assets. They exist independently of any claims on counterparties. They are not just financial wealth.
Investing in this space also lets you continue to make profits. That’s what James Allen is up to at our new Exponential Energy Fortunes. And he’s discovered an energy play set to revolutionise your understanding of energy markets. And your bank balance.
Until next time,
Nick Hubble
Capital & Conflict
Category: Economics