Sometimes just a quarter turn too far on a bolt or a screw can result in a crack or a stripped thread, with the sudden release of tension triggering that sinking feeling of dismay at the problems that lie ahead in fixing the mistake.
That’s what global stocks are feeling now after the US Federal Reserve cranked up global benchmark interest rates to the point where the US bond market cracked, with some longer bond yields “inverting” below the shorter end where the Fed had far more influence.
This break down in the natural order of an ascending “yield curve” — a plot of yields from overnight rates out to 20-year yields — is now the second stage of what historically has been a reliable recession indicator. There’s also inversion in the globally important “eurodollar” market where companies and banks around the world access US dollar funding.
Yield-curve inversion in bond and funding markets is a recession indicator primarily because it reveals long-term investors are not confident enough in long-term growth prospects to bet their capital on riskier investments with potentially much greater rewards, such as growth companies, infrastructure and capital equipment-related projects.
Instead, there is a tendency to park billions of dollars of capital in long-bonds, despite central bank rate hikes, with the strong demand depressing yields.
Higher short-term yields relative to long yields also reduce the incentive for banks to “borrow short and lend long” — because there is no longer sufficient margin difference between the two ends to justify the risks over time, thereby slowing the pace of money creation in the economy.
The Bank of International Settlements’ monetary and economic department chief Claudio Borio revealed last month that global central banks such as the Fed and the Reserve Bank still did not have the monetary equivalent of a torque wrench to accurately apply correctly measured interest rate adjustments because their economic models did not include a financial system. Instead they rely on crude, lagging indicators, and experience based on previous economic cycles that have only made global economies more fragile from indebtedness.
So after months of vowing to turn the screws much tighter still to keep inflation from breaking out of the monetary box and into the broader economy, last week Fed officials suddenly looked up from zealously fulfilling their task and blinked, having finally noticed that the rate screw was turning but no longer tightening all the way out along the yield curve.
Falling house prices, car sales and industrial production were the cracks they suddenly saw.
As is their wont, denial has Fed officials suggesting that maybe if they take a break for a month or two the economy will repair itself, allowing them to make a few more turns.
Also, the Fed is conducting “quantitative tightening”, or selling bonds into the market, the exact opposite to the quantitative easing that ignited the global “search for yield” from about 2012.
Ignoring Fed optimism, the collective wisdom of bond investors has strongly swung to saying the Fed has again tightened beyond a point where too many over-indebted households and companies have come under debt stress, forcing them to reduce spending in a downward spiral towards broad default and recession.
And global equity markets have noticed, too, just as they did when peaking in November 2007.
The Fed is guaranteed to be slashing rates in the not too distant future, thereby “steepening” the yield curve again in an attempt to revive bank lending and money creation.
But by then it is likely to be too late because the damage in the interim between optimism and reality is almost always too long.
In Australia, outwardly the Reserve Bank had been almost as optimistic as the Fed but not enough to change interest rates for a record 28 months.
The Aussie yield curve is flat and inverted between two and three-years, too, while Fed tightening has resulted in a steep rise in eurodollar rates to 2.65 per cent. That has filtered back into elevated six-month bank bill swap rate of 2.13 per cent, far in excess of the Reserve’s 1.5 per cent overnight cash rate and above five-year yields around 2.05 per cent.
Banks have passed some of these wholesale costs on to households via higher mortgage rates, which combined with the clampdown on lending standards has knocked house prices and construction-related spending, investment, and most importantly lending-related money creation.
Defying what’s perceived as a “strong” jobs market, just like the US, Wednesday’s GDP report showed growth of just 0.3 per cent over the September quarter, half of forecasts, and 2.8 per cent annualised.
Government “public” spending on infrastructure made a strong 4.5 percentage point contribution to growth that offset broad consumer weakness and the falling company investment.
But that spending has pushed total government debt to $537 billion and comes at the cost of draining funding from other investments, such as stocks.
And that goes a long way to explaining why the S&P-ASX 200 index has been stuck in a trading range for the past two years.
Capital is needed elsewhere to meet the infrastructure backlog-after record immigration over the past five years.
While the domestic yield-curve dynamics are not positive and risks of an official domestic rate rise to pressure households is next to non-existent, money-creation is in the process of being throttled by changes from the Hayne royal commission.
UBS bank analyst Jonathan Mott noted this week that times have now changed with “the bankers being schooled” by the royal commission on the new four Rs of banking: remuneration, remediation, regulation, and responsible lending.
“The risk of the current credit squeeze turning into a credit crunch is real and rising, with the housing market now falling sharply, “ Mr Mott said. “The banking sector is facing a period of substantial and sustained earnings pressure which is likely to last several years.”
The crunch won’t be Reserve induced, but the effect will likely be just the same.
All that explains why the Reserve also blinked on Thursday, with assistant governor Guy Debelle admitting uncertainty about housing and potentially the economy could warrant a policy response, including quantitative easing.