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The bond market is screaming

The following commentary by Paul Krugman is from a current column in the New York Times. It has not been abridged.
An old line about war says that amateurs talk about tactics, but professionals study logistics. A similar line about the economy would be that amateurs talk about stocks, but professionals study the bond market. And lately the bond market is telling a tale of profound pessimism.

Why does the bond market reflect economic expectations? If investors expect a boom, they also expect the Fed to try to rein in the boom by raising short-term interest rates (which it more or less directly controls), to head off potential inflation. The prospect of higher short-term rates then leads to higher long-term rates, because nobody wants to lock money in at a low yield if returns are going up. Conversely, if investors expect a slump, they expect the Fed to cut rates, and pile into long-term bonds to lock in returns while they can.

So the slump in long-term yields since last fall, from a peak of 3.2 percent to just 1.63 percent this morning, says that investors have grown drastically less sanguine about the economy. Long-term rates are now notably lower than short-term rates — and this kind of “yield curve inversion” has in the past consistently been the precursor to recession.

Bond investors could, of course, be wrong — there are some people out there claiming that we’re in a bond bubble. And so far the real economy, as measured by G.D.P., job growth, and all that, is still chugging along. But as I said, there’s clearly a wave of pessimism sweeping the market. What’s it about?

One answer is that last fall many investors were looking at a couple of quarters of high growth, and thinking that this might be the start of an extended boom. Serious economists warned that this growth was a temporary lift — a “sugar high” — driven by the shift from fiscal austerity to what-me-worry deficit finance. But at least some people bought into the Trumpist line that tax cuts were going to produce an enduring rise in the growth rate.

Since then, however, it has become clear that the tax-cut boost was indeed a one-time thing. In particular, there has been no sign of the promised surge in business investment.

At the same time, Trump’s trade war may be starting to take a toll. In particular, the uncertainty may be deterring business spending. Whether new tariffs would hurt or help your business, it now makes sense to hold off on plans to expand, until you see what he actually does.

Finally, economic troubles in the rest of the world — several major European economies are quite possibly in recession — are filtering back to the U.S.

Now, most economists aren’t predicting a recession here, for good reason. The truth is that nobody is very good at calling turning points in the economy, and calling a recession before it’s really obvious in the data is much more likely to get you declared a Chicken Little than hailed as a prophet. (Believe me, I know all about it.) But the bond market, which doesn’t worry about such things, is looking remarkably grim.

I leave the possible political implications as an exercise for all of you.


  • edited August 14
    It takes Krugman 529 words to say that none of us understands wtf is going on with interest rates?

    Edit: Kinda busy today. Some chopped up observations ... I don’t think Krugman’s wrong. He just tosses out a number of possibilities - already widely understood.

    What I suspect may be the unmentioned elephant in the room is (broadly defined) global demographics. Many nations are experiencing declines in working age populations and increases in the elderly. And, the elderly are living longer. A lot of the change relates to the devastation / loss of life stemming from WWII. Babies born shortly after the war ended are now 70-75 years old.

    That demographic shift puts enormous pressure on income producing instruments because the elderly have shorter anticipated time horizons over which to invest and lower risk tolerance in general. Bonds, including those held via various insurance products, become an investment of choice for a growing sector of the populations in the more advanced (wealthier) global economies. This drives rates downward.

    So, what accounts for the seemingly unstoppable gains in equities? That’s more complicated. But I suspect a few factors: (1) the loss of defined benefit retirement plans has driven many inexperienced investors into the equity markets leading to more exaggerated boom & bust cycles; (2) money has been driven into equities the low and lower interest rates, (3) global productivity has increased due to the technology revolution. (4) To some extent, the advent of “instant feedback” brought about by the web has prompted more risk taking by market participants than when we relied mainly on time-lagged print sources for news and information. (Think of the “casino effect” on human behavior.)
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