You are here:

Recession and bond yields

Created:
18 November 2008
Written by:
Chris Dillow

The US economy is heading for its weakest period for almost 50 years. This is because the recession will combine with a sharp fall in inflation to cause annual money GDP growth - which was 3.4 per cent in the third quarter - to fall below 2 per cent for the first time since 1961. It might even turn negative, which hasn't happened since 1958.

Advertising

If history's any guide, this would reduce bond yields. Since 1960 there has been a good correlation (0.44) between annual money GDP growth and the level of 10-year Treasury yields.

There's been an even stronger correlation (0.79) between 10-year yields and trend money GDP growth, as measured by average annual growth over five years. Trend growth alone explains over three-fifths of the variation in the level of yields since 1960. And we can't rule out the possibility that, on average, 10-year yields are equal to trend money GDP growth*.

This relationship implies that each percentage point fall in trend money GDP growth is accompanied, on average, by a percentage point fall in yields.

But, surely, everyone knows money GDP growth will fall. So the bond market must be already discounting this, mustn't it?

Not necessarily. Yes, yields are now a little lower than their traditional relationship with trend growth would predict. But this could be just noise, of perhaps the effect Chinese and Middle Eastern buying is having in reducing yields. It needn't be because the market is anticipating slower growth.

Indeed, history suggests it usually doesn't do this.

The strong correlation (0.79) is between yields and past growth - that is, between yields now and growth in the past five years. Correlations between yields and subsequent growth are lower. For example, that between the 10-year yield and centred trend growth (say between the yield in September 2003 and growth between September 2001 and 2005) is just 0.48. And that between the yield and subsequent trend growth is just 0.15.

This suggests that, on average, the market doesn't successfully look ahead.

Which in turn suggests that - contrary to common sense - recession and disinflation might reduce yields still further. Unless, that is, fears about rising government debt and falling overseas buying offset this.

*Regressing the yield on trend growth gives the equation: Yield = -0.3 + 1.0 x growth. The standard error on this intercept is 0.41, which suggests its possible that the true intercept is zero.

  • Back to top

Win £1,000 or a golf weekend

Enter IC's Fantasy Portfolio competition for the chance of winning £1,000 or a luxury golf weekend, courtesy of ETX Capital and Celtic Manor.

Enter here for your chance to win

Advertorial Feature

Take control of your investing with CFDs

Have you ever watched a move in the markets that you saw coming, but you weren't able to exploit?

by Dominic Picarda

Advertorial Feature

Spread your risks with spread trading

With so many big moves in the world's financial markets, there have seldom been more opportunities around for spread traders. Isn't it time you joined them?

by Dominic Picarda