By David Prattent

Marketwatch has put the financial press aside for a couple of days.  It’s all making his head hurt. And worse, the volume of the news has meant he hasn’t had the chance to study his September wine catalogue.

The yield curve has inverted! Man the lifeboats!  Hide your savings under the bed, financial Armageddon has arrived.

Or has it? Its pretty technical but let’s go back to some basics.  This is all about the bond market and its importance to the world at large. Issuing bonds is the way governments, and some companies, borrow money.

Let’s say the Australian government sells me $1,000 in bonds and, for the next ten years it will pay me 3%.  At the end of the period it will give me back my $1,000.  The yield on my investment is the rate I get on what I paid for the bonds, so its 3%.  But I’m an impatient soul and after two years I sell my bonds to a bloke called Doug who I met at the pub.  Doug paid me $1,100 for my bonds so I was pretty chuffed.  Doug, however, still only gets the 3% paid on the original $1,000 so his investment yield is 2.7%.  On a vast scale, these transactions take place every minute of every day.  It’s a simple equation; the market price of bonds goes up, the yield goes down, and vice versa.

Governments borrow over different periods ranging from 1 month to 30 years and, more recently, some countries like Austria are doing it over 100 years.  The so-called yield curve is a graphical plot of the different yields of 1 month, 3 month, 2 year, 5 year, 10 year, and 30 year bonds for an individual country.  Generally, buyers of bonds expect a higher yield for longer dated bonds because they expect to be compensated for the added risk of owning longer dated bonds because their money is tied up for longer periods (provided they do not sell).  When each yield is plotted out, with lower yields for shorter stocks and higher ones for longer dated versions, there is an upwards curve.

When the curve goes downwards over time, it is a signal that bond purchasers are more pessimistic about the future.  So why did they buy the bonds if they knew the yield was going to be that poor?  Generally, its pretty much all about safety.  Typically, if the economic times look tough, people with money (I mean really serious money.  A lot.  A jolly lot.  Billions.) want to park it to protect it as much as possible.  They take it out of shares and put it in bonds because government debt is supposed to be a safer bet.  Unless you put it into Venezuela which rivals roulette for a safe bet.

Global economic growth is slowing and risks are increasing.  Money is looking for a safe place so bond yields are going down as funds are moved into government bonds from riskier investments like shares.  Yields on longer dated bonds have gone down faster so the yields curve has inverted, or has curved downwards over time rather than upwards.  These movements are generally accompanied by volatility in share markets and we are certainly seeing plenty of that.

In the United States this is being interpreted as a sign that a recession is on the way.  On the other hand, it is possible that there is so much demand for bonds that, just like any other commodity, demand is driving up prices (and consequently driving down yields).

The amount of money now in the global system is huge.  After the global financial crisis, the four biggest central banks (United States, Japan, United Kingdom and the European Central Bank) put an extra, yes extra, $9 trillion in their economies.  The term they use is “quantative easing” so it sounds really cool. It’s all still there and as it moves around, it makes waves.  Hopefully there will not be a tsunami.

As for recessions?  Maybe yes, perhaps no.  Maybe mild, perhaps severe.  The inverted yield curve might be predicting one.  But as the famous economist Paul Samuelson once said “The stock market has predicted nine of the last five recessions.”

Whatever happens, hang on to your hat, its going to be an interesting ride.  Think hard about investing.  Do your research, not just on the investment but the wider risks in our economy.

At a recent meeting of world bankers, a senior member of the US Federal Reserve Board commented, “We just have to stop thinking that next year things are going to be normal.”

In 1966 Robert Kennedy gave a speech in which he said “There is a Chinese curse which says “May he live in interesting times.” Like it or not, we live in interesting times.  They are times of danger and uncertainty, but they are also the most creative of any time in the history of mankind.”  Although the Chinese origin of his quote is dubious, I am reminded, 43 years on from Kennedy’s statement, of the French quote from the 19th century, “plus ҫa change, plus c’est la même chose” (the more things change, the more they stay the same.”).

And Marketwatch?  Well, he has unearthed a bottle of King Valley Cabernet Sauvignon which has never heard of a yield curve, let alone an inverted one.  And at least he will totally understand why his head hurts in the morning.

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