Britain’s inverted yield curve is nothing like America’s

INVERTED yield curves are the hot topic of the summer, especially as UK gilts have followed US treasuries by offering more interest on two-year maturities than you’ll get on 10-year notes.

When the sovereign bond world is flipped on its head like this it’s often seen as an indicator of looming recession as investors scramble for the relative safety of longerterm debt, which in turn pushes down its yields. The phenomenon has been seen before the last seven recessions in the United States.

But what happens in America doesn’t necessarily always apply in Britain. As I’ve written before on yield curve inversions, they tend to be more of a harbinger of doom the longer they hang around. Briefer periods of things going topsy-turvy aren’t as troubling, and we haven’t moved beyond that stage yet.

Another thing to bear in mind this time around, particularly in the smaller UK market, is the hugely distorting impact of quantitative easing (QE) over the past decade and the sheer volume of bonds snapped up by the Bank of England (BoE) and other central banks.

The BoE owns about one-third of all gilts, which makes it very difficult to read any economic signal from how the UK bond market is working. That’s proportionately a much higher holding than the QE programmes undertaken by the Federal Reserve or the European Central Bank. If Threadneedle Street buys up lots of long-dated bonds because of monetary policy then that will push down their yields without telling you much about the expectations of a downturn among general investors.

Neither does British market history show much evidence of briefly inverted curves leading to recession. Other than the tumult of 2008 and 2009, there hasn’t been a recession in the United Kingdom since 1991. The global financial crisis was indeed preceded by an inversion of the gilt curve between two and 10-year bonds but that’s the only clear-cut example in recent years.

While there was a long period of yield curve inversion between 1997 and 2002, the economy kept growing although it did slow up after the deepest points of the inversion. But there was also a sharp drop in gilt issuance at that time.

The UK economy is holding up pretty well despite the 0.2% drop in the three months to June. The third quarter should see a bounce back of 0.3%, according to Dan Hanson of Bloomberg Economics, while his forecast for 1.2% growth in 2019 is unchanged. July retail sales growth of 0.2%, and an upward revision to the June data to 0.9%, shows consumer spending is holding up.

With the spectre of a no-deal Brexit hanging over the UK economy it’s tough to draw a conclusion about the future. Only when Brexit is resolved will any fiscal boost or further BoE stimulus be determined. The UK’s yield curve inversion is worthy of concern but it’s as much about a shortage of available bonds than any sure sign of trouble ahead. — Bloomberg

The views expressed here are solely that of the writer.