A sharp sell-off in bonds just days after investors rushed to the safety of fixed income markets sends conflicting signals about the US economy and the global dovish tilt.
On Monday, the US Treasury market posted its biggest one day sell-off in three months following the release of better than expected manufacturing data from China and the US.
The yield on US 10-year Treasuries climbed nearly 9 basis points for the biggest single-day jump since January 4, breaking above the 2.5 per cent level.
On Tuesday, the Reserve Bank of Australia punctured the more upbeat mood, saying growth has slowed and downside risks ‘‘have increased’’. This caused Australian 10-year bond yields to dip, from 1.835 per cent immediately before the decision, to 1.812 per cent. They hit a record low 1.72 per cent last week.
But the positive implications of a selloff in US Treasuries may not be enough to erase the memory of the inversion of three-month and 10-year US government bond yields for the first time since 2007. The historic move, which happened on March 22, is a classic signal of recession.
BNY Mellon’s John Velis said the yield curve inversion matters.
An inversion is not insignificant, said Dr Velis, BNY Mellon’s new head of macroeconomics and foreign exchange. “It’s almost axiomatic that when the curve inverts, low growth and usually a recession follows.”
It is frequently argued that years of bond purchases by the US Federal Reserve have made the yield curve a less reliable barometer of the economy’s health than in the past.
Dr Velis, who joined the $1.7 trillion asset manager from State Street last year, rejects this. “You hear a lot of people tell you, ‘Well, it’s different this time because the Fed has bought all the bonds at the long end of the curve, and so have other central banks, so the curve doesn’t show the same sort of information that it used to’. It’s not your father’s yield curve in other words.’’
He disagrees. “If you look at why long bond yields have fallen, it’s because inflation expectations have fallen. I learnt the hard way in 1999 when the US curve inverted.
‘‘At that time I was telling people, ‘Don’t worry about it because inflation’s lower than it has ever been,’ and the government at the time, believe it or not, was running a balanced budget.
“So I was going around telling people the flat curve back in 1999 is not the same curve that we have been looking at since the end of World War II. It was, and since then I’ve been very reluctant to dismiss any signals from it.”
Dr Velis pointed to a similar flattening of the Canadian, Australian and German yield curves as examples of how bond markets are reflecting lower economic growth in other parts of the world.
Australia’s yield curve has also inverted, on both the three-month bank bill and less-liquid three-month Australian government bond measure. The last Australian yield curve inversion occurred in July 2016.
Market-based measures of domestic inflation expectations have also hit record lows.
The Fed is keeping a close eye on what is happening outside the US economy, Dr Velis noted. “They choose their words carefully but if you keep pointing out international concerns in a very sort of high-level way, that means that there are really some international concerns.”
The strategist admitted to being impressed that the Fed changed its stance on interest rates so quickly, pivoting from raising rates in December last year, to telling markets in January that it would be patient. At its March meeting, it removed all expectations for rate increases in 2019.
‘‘I’m kind of pleased that they were able to reverse as quickly without worrying what the PR effect would be on it. That’s impressive.
‘‘I said in December that we would be more likely to talk about rate cuts at the end of 2019 than we would be talking about how much further the Fed was going to be hiking at that time. I just didn’t expect that it would happen by the end of March.’’
Dr Velis believes the central bank has been paying attention to data that ‘‘a lot of people have been ignoring’’, including lower investment, and signs that the labour market is cooling, evidenced by unemployment insurance claims halting their decline.
Broadly, he predicts that investors will become more defensive.
He is also on alert for a rise in abnormally low foreign exchange market volatility: ‘‘Typically what happens is that when it breaks, it breaks very quickly and suddenly and people rush for the exits.
‘‘Whether or not this dovish turn by the Fed will be enough to sort of stem that tide and give people confidence and prevent a large crash and the disruption from rising volatility remains to be seen. In the past this has not been the case.’’