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Macro View: Bond market rout reinforce fears of impending crisis

MOST equity markets continued to drift at levels near to their multi-year highs, giving a misleading impression of calm and stability. But massive gyrations in sovereign bond markets conveyed timely warnings that new storms may be approaching, which may engulf not only share prices but also the wider real economy.

Recent violent fluctuations in bond yields and prices were almost unprecedented, particularly in the eurozone. German ten year bund yields, after hitting a record low of almost zero in mid-April, bounced back to 0.74% early in May, before settling at 0.55-0.6%. After a long period of sharp falls in bond yields, with many maturities in negative territory, there was a dramatic reversal. Yields spiked, prices plummeted and bond holders were forced to accept huge losses, even though yields are still very low by historical standards

In normal circumstances, the combination of high share prices and rises in bond yields would be a welcome signal that deflation fears are receding and growth rates may at long last be returning to more normal pre-recession levels. With oil prices now well above their recent lows and rising, it is plausible to take the view that inflation is now edging up and deflation will soon cease to be a concern. But weaker growth forecasts in most regions will heighten worries over secular stagnation, and underline fears of an impending crisis.

Pessimistic interpretation

If bond yields continue to edge up in the face of weak growth and aggressive quantitative easing (QE) policies, one would have to conclude that weak productivity, adverse demographic trends and other supply constraints preclude a return to stronger growth, even though inflation is now rising. If this view proves to be correct, trying to boost demand through higher doses of QE is futile and counter-productive, and may therefore have to be abandoned. We may reluctantly have to live with weaker growth.

It is premature to accept this pessimistic interpretation. The eurozone, where growth forecasts are now being upgraded, is an important exception to the general pattern of weaker prospects. The European Central Bank’s decision a few months ago to launch an aggressive QE programme is now arguably producing positive results. These trends are welcome. But it is far fetched to expect the eurozone economy, which is still basically weak, to become the new global locomotive.

Eurozone GDP growth in 2015, though revised up to 1.5 %, is still weaker than in the US and the UK. Moreover, one cannot ignore the escalating threats that would arise if Greece is forced to default on its debts. If the ECB fails to stop Greece from leaving the euro in the event of a default, the consequences could be dire. The fact that Germany and other “core” economies in Northern Europe are opposed to QE, and are reluctant to support weaker economies, will make it more difficult for the ECB to limit the damage of a major crisis. With unemployment at 11.3%, still twice as high as in the US and the UK, and with inflation at zero, risks of a eurozone setback remain high.

In contrast to the improvement in Europe, trends in the US have been disappointing. Although the American economy continues to enjoy better long-term prospects, recent US developments have heightened fears that the recovery may now be stalling. GDP slowed very sharply, from an annualised 2.2% in the last three months of 2014, to a negligible 0.2% in the first quarter of 2015.

Harsh winter weather, a strong dollar, and shipping interruptions due to labour disputes, all contributed to the slowdown. But the virtual stagnation in the first quarter was much worse than expected. Industrial output fell in March and recorded the first quarterly decline since 2009. The US labour market has also lost momentum. Although the economy created 223,000 jobs in April, the puny March figure was revised down further. Longer term trends show a clear slowdown in jobs growth, from a strong monthly average of 324,000 in the fourth quarter of 2014 to only 194,000 jobs in the first four months of this year.

Signs of weakness

While there is little risk of recession, our 2015 US GDP growth forecast is lowered markedly from 3.0 to 2.5%. The weaker momentum in the US economy will exert powerful pressure on Federal Reserve chairwoman Janet Yellen and her colleagues to postpone the first hike in rates. A June move, which appeared imminent until recently, is now unlikely, even though the Fed is uneasy about inflation. Though all-items annual consumer inflation was slightly negative in March, at -0.1%, this largely reflects a fall of 18.3% in energy costs. Core inflation, which excludes energy and food, rose to 1.8% year-on-year, and this complicates the Fed’s job.

Signs of weakness in China are adding to concerns over a long-term global slowdown. Year-on-year growth in the first quarter of 2015 was 7%, the worst figure in six years. This follows full-year growth of 7.4% in 2014, the lowest rate since the early 1990s. Slower Chinese growth is an unavoidable trend, driven by demographic and structural changes, as demand relies less on investment and more on consumer spending. But there are fears that worsening debt problems in the property market may destabilise the economy. Exports fell 6.4% year-on-year in April, while imports plunged by 16.2%.

China’s growth may drop below 7% in 2015. In order to pre-empt risks of a “hard landing”, which could cause bankruptcies and bad debts, the central bank has again cut interest rates, for the second time this year, and lowered banks’ reserve requirement ratio (RRR). But with signs of slowdown intensifying, we expect the Chinese authorities to cut interest rates further and inject additional stimulus, both monetary and fiscal, in the next few months.

The UK delivered a pleasant surprise to the markets, in spite of disappointing growth trends. David Cameron’s victory in the UK’s General Election, with a small but clear overall majority in Parliament, defied all the opinion polls that predicted an inconclusive result and a prolonged period of political instability. Fears that a minority Labour Government, which will rely on Scottish Nationalist support, may be unfriendly to business, have given way to a sense of relief that the policy environment is likely to remain stable.

There is some unease over the forthcoming negotiations over the terms of the UK’s future membership of the European Union, and the subsequent referendum. But there is now cautious optimism that it would be possible to avoid a disruptive British exit. Preliminary GDP estimates for thee first quarter of 2015 show a marked slowdown in quarterly growth to 0.3%, down from 0.6 per cent in the fourth quarter of 2014 and below most analysts’ expectations. Given the strong increase in jobs, the GDP figures probably understate the momentum in the economy. But our 2015 growth forecast is lowered. The UK recovery is clearly facing obstacles and it is vital not to put it at risk. The MPC must persevere with low interest rates for the time being.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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