Financial crisis start under blue skies, as investors in emerging markets know too well. They lead rather than follow business recessions. Ultimately, they are caused by a sharp tightening of liquidity conditions and collapsing investors’ risk appetite.
Arguably, the most important price to watch in financial markets for an early-warning sign is the price of the dominant economy’s debt. This is best measured from the US interest rate term structure, which is popularly summarised by the slope of the yield curve between the yields on 10-year US Treasuries and the Federal Reserve’s short-term policy rates.
A flat or inverted yield curve is widely interpreted to signal upcoming business recession and widespread disruption across emerging markets, by damaging the rapacious appetite of US consumers and shutting off the flows of cross-border capital. Therefore, what should we make of persistently flattening national yield curve slopes over the past year and the recent media claims that the notional “G4 yield curve has just inverted”?
In practice, this single yield spread is only an accurate predictor in those rare cases of perfectly linear term structures. This is because the distribution of yields and by implication the pattern of term premia — the extra yield required to hold longer-dated bonds rather than rolling shorter tenors — across the term structure matter.
This is especially true today because the quantitative easing and forward guidance policies adopted by the major central banks have arguably distorted the shape of the interest rate term structure.
It is helpful to think of the yield curve as broadly consisting of two distinct parts: a front-end, say, up to around 3-year maturities that is dominated by future policy rate expectations, and a back-end, say, 5-to-20-year maturities that is largely influenced by term premia.
These term premia, in turn, reflect the general risk-seeking behaviour of investors, with 10-year government bonds, whether Bunds, gilts, JGBs or US Treasury notes, being the canonical “safe” assets for many institutional investors.
The movements in term premia and in the slope of this “second” longer-dated yield curve are barometers of risk appetite and reflect the net demand for these “safe” asset bonds. Hence, it is popularly argued that, by reducing the effective supply of “safe” assets, the QE policies of central banks have distorted the term structure by narrowing term premia.
However, this leaves aside the more important fact that to purchase these bonds, central banks must simultaneously inject liquidity into financial markets. This, by definition, reduces systemic risks, loosens leverage constraints and, by encouraging more risk-seeking activity, reduces the need for “safe” assets.
The bottom line is that far from lowering yields and term premia, these QE policies actually raise them. In other words, the stark collapse back from their decade highs in worldwide bond term premia at these longer-dated maturities is not a distortion caused by overly-generous QE, but may instead reflect an unambiguous and growing demand for safety by the key investors.
Thus, the 10-year/5-year yield spread, in particular, has been fast-narrowing in the US, UK and Europe. It is this second, “flatter” and longer-dated yield curve that we should take very seriously as a warning sign of falling liquidity, heightened systemic risk and the threat of an upcoming financial crisis. And, it is now flashing red for both emerging and developed market investors.
