If global markets are unsettled, they have good reason to be so

Last week’s upheavals in bond values were an all-too-rational response to a cocktail of economic troubles

Every year the Federal Reserve Bank of Kansas City hosts a symposium in the Grand Teton resort of Jackson Hole. Some years, guests have little to do but chew the fat and listen to distinguished speakers explain points of economic importance. Sometimes, though, the conclave in Wyoming takes place with a crisis looming. One such year was 2008. This year is shaping up to be another.

Global financial markets certainly fear the worst. Share prices slumped last week amid fears that the first recession since the big crash of 2008-09 is just around the corner. The trigger was developments in the bond markets, which is where investors trade the debt that governments issue to cover their spending.

More specifically, the problem was caused by the inversion of the yield curve, and overnight the media was awash with explanations of what that meant. This in itself was a worrying development. As a general rule, when the argot of the City becomes part of everyday parlance, it spells trouble ahead. No one outside the markets had heard of collateralised debt obligations before they brought the entire banking system to the brink of collapse in September 2008.

Stripped back to its essentials, an inverted yield curve means investors think there is more risk in holding short-term government bonds than long-term ones. Normally it is the other way around, on the grounds that the longer a bond’s duration, the greater the risk.

What’s more, there is a correlation in the US between an inverted yield curve and recession. The last time the yield – in effect, the interest rate –on two-year US treasury bonds was higher than on 10-year bonds was 2007, and within months the world’s biggest economy was plunged into its deepest slump since the Great Depression of the 1930s.

It is by no means always the case that an inverted yield curve leads to a recession. And even when it is the harbinger of bad times, there can be quite a delay before the storm breaks. Stock markets could go on another surge before a recession arrives.

All that said, the market tremors of last week were entirely rational because there is plenty to be worried about. The world’s two biggest economies – the US and China – are in the middle of the most serious trade dispute since the 1930s, one that neither country can win.

Protectionism is having knock-on effects on factory output, not just in China but in the heartland of Europe. Germany, with its industrial motor stalled, has already suffered one quarter of falling growth and could easily be heading for a second.

Not that Germany is Europe’s only headache. There is the long-running saga of Brexit, which looks like coming to a head this autumn.

Then there is Italy, which could prove to be an even bigger problem. Italy has been in and out of recession for more than a decade and living standards are barely any higher than when the country became a founder member of the eurozone in the late 1990s. Italy’s populist government would like to borrow more to boost growth, even though that means busting the eurozone’s budget rules, and the country’s de facto leader, deputy prime minister Matteo Salvini, is keen to hold an election that could result in a hard-right government with a mandate to take on Brussels.

Donald Trump’s increasingly vitriolic attacks on the Federal Reserve, the US central bank, are an indication of how fragile things are. The president is keen to have a fall guy in case the economy struggles during his re-election campaign, and has found one in Jerome Powell, the man he chose to run the Fed. Trump says that any damage caused to the economy will be the fault of Powell for raising interest rates too aggressively and being too slow to cut them. The campaign for a U-turn has been successful: the Fed has already started to reduce borrowing costs and looks set to provide more economic stimulus this autumn. Likewise, the European Central Bank has promised a package of measures next month.

Such action will help, at least in the short term, to calm the markets. A comprehensive trade deal between Beijing and Washington would send share prices soaring. But that looks unlikely, and as things stand the question is whether the global economy is heading for a slowdown or a recession.

On average, there has been one serious downturn per decade since the early 1970s. One is due.


Larry Elliott

The GuardianTramp

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