The bond market agrees with Elizabeth Warren, up to a point

Sen. Elizabeth Warren (D-Mass.) is not known for her enthusiasm for the financial markets in general and for the bond market in particular. But there seems to be one important point on which Warren and the world’s bond markets currently agree: both the U.S. and the rest of the world could soon be heading for a nasty economic recession.

In a recent article, Warren warned that the odds of another economic downturn were high and growing. In her view, this is due to the precarious state of our economy, which is built on an excessive amount of household and corporate debt. That makes the U.S. economy particularly vulnerable to a number of serious shocks that she now sees on the horizon and that she thinks “could cause our economy’s shaky foundation to crumble.”

By its nature, the bond market does not spell out the reasons why it prices bonds in any particular manner. But we can infer the bond market’s economic outlook from market bond prices.

One indication that the government bond markets now seem to be sharing Warren’s gloomy economic prognosis is the fact that long-term U.S. Treasury bond rates have declined to significantly below the Federal Reserve’s short-term policy rate. This so-called yield curve inversion implies that the U.S. Treasury bond market is expecting that the U.S. economy will soon go into a recession that will keep interest rates low for a long time.

A more dramatic indication of sovereign bond market pessimism is the fact that a record US$13 trillion of global sovereign bonds, and around one half of all European sovereign bonds, now offer negative interest rates. As an example, for the dubious privilege of lending to the German government money for ten years, an investor today would have to pay the German government 0.3 percent a year. This implies that these bond markets are expecting that gloomy global economic conditions will keep inflation down at an unusually low level for the indefinite future.  

To be sure, while global sovereign bond markets are now signaling that real trouble might lie ahead, global equity and credit risk markets are telling a much more upbeat story. Indeed, they are partying as if there were no tomorrow with the U.S. equity market setting new record highs on a routine basis.

However, considering that the bond market is generally a much more accurate forecaster of economic recessions than is the equity market, economic policymakers and stock market participants should be asking themselves whether they are missing something that the sovereign bond market is seeing.

It could be argued that the sovereign bond market is generally sensitive to economic and political risks. However, what seems to have it on high alert now is that this time around there are an unusually large number of such risks with a high probability of materializing in a group of systemically important countries. 

Among the more immediate of these risks is that the United Kingdom, the world’s fifth largest economy, could soon crash out of the Euro without a deal as Boris Johnson, the U.K.’s soon-to-become prime minister, is threatening to do. That would almost certainly deal a major body blow to the U.K. economy and have significant spillover effects to a European economy that is already on the cusp of a recession.

A still more serious, albeit less imminent, threat is the risk that we could have a recurrence of the Italian sovereign debt crisis. With the Italian economy being approximately ten times the size of that of Greece and with it having the world’s third-largest sovereign debt market, an Italian debt crisis would pose an existential threat to the Euro’s survival and to the European banking system. The European economic crisis that would ensue would almost certainly reach our shores.

Another serious risk to the global economy is President Trump’s America first trade policy. That policy has already resulted in a marked slowing in the Chinese economy that in turn has had important spillover effects to China’s regional trade partners as well as to the highly export-dependent German economy. 

Although a truce was declared in the U.S.-China trade war at the recent Osaka G-20 Meeting, there remains the real risk that it might be short-lived. This would appear particularly to be the case considering that the Trump administration is increasingly viewing China as a strategic risk rather than as a reliable economic partner.

After the U.S. Commerce Department’s determination in March that European and Japanese automobile exports constitute a national security risk, there is also the real risk that Trump will follow through on his threat to impose a 25 percent import tariff on European and Japanese automobiles. Such a course of action would almost certainly sink the currently weak and export dependent German economy.

At a time that the world debt to GDP ratio is at a record level, a triggering of any of the economic risks identified above, not to mention a geopolitical event like that of the closing of the Strait of Hormuz, could have major repercussions for the U.S. and the other global economies.

On this point the bond market very much agrees with Warren. But it is doubtful that it would also agree with her that the way out of this morass is to forgive student loan debt, enact her Green Manufacturing Plan, strengthen unions, provide universal child care and raise the minimum wage.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging marketdEconomic strategist at Salomon Smith Barney.