The past week or so has seen risk aversion really take hold in financial markets. Despite S&P's downgrade of the US credit rating, yields on ten-year US Treasuries (USTs) reached 2.07% last week, within a whisker of the trough at the height of the financial crisis in 2008. At the same time, 10Y German and UK yields have also fallen, as investors have sought safe havens.
Government bonds are one way that financial markets can help the economy, in a similar fashion to the government's automatic stabilisers. With the latter, things like unemployment benefit tend to get paid out much more in recessions, as more people lose their jobs, thereby providing a boost to incomes and the economy. With bond markets, the mechanism is a little different. As investors get nervous about the outlook for growth and seek safe havens where they are confident they will get their money back, that pushes down the benchmark yield (interest rate) on government bonds. And because those bonds act as reference prices for other investments – notably corporate bonds, but equities as well – lower interest rates feed through to the rest of the economy, thereby boosting growth.
Or at least that is the theory. The reality, as we are seeing at the moment, is that short- to medium-term concerns about economic prospects matter far more for the medium-term growth outlook than another 0.2% or even 0.5% off long term interest rates. Indeed, it is hard to find a strong causal relationship between long-term yields and long-term growth in many advanced economies, let alone long-term yields and growth over shorter horizons.
One difference, this time around, is that investors have also been turning to other safe havens. Commodity prices are, if anything, pro-cyclical, so it might seem odd that investors are turning to metals as a source of refuge. But with the gold price now trading around $1900, that is clearly what they are doing. In part, this reflects a hedge against possible dollar weakness, which could be triggered by more QE from the Fed.
The problem is that the risk aversion ends up becoming self fulfilling. Consumer confidence is already low in most Western economies, as households continue to slowly grind through their accumulated debts. Businesses are also subdued, with smaller firms still struggling to access funding and larger companies unwilling to commit their cash piles in the face of continued economic uncertainty. If bond prices continue to climb as investors shun risk (and equities), that could feedback to sentiment and spending elsewhere in the economy and could genuinely push countries – notably both the US and the UK – back into recession.
Normally, this would be the point at which we'd expect policymakers to step in and shore up the economy. Sometimes large-scale Keynesian-style interventions are necessary, to avoid economic catastrophe. Left unchecked, persistent unemployment can blight any economy.
Unfortunately, there doesn't seem to be much chance of stimulus any time soon. In the US, Federal Reserve Chairman Bernanke seems reluctant to commit to further support. The second bout of quantitative easing (QE) has not succeeded in bringing the unemployment rate down, and deflation is arguably less of a concern than it was three years ago. At the same time, although Rick Perry (www.rickperry.org) is clearly a bit of an economic nutter, his comments may also be weighing on monetary policy makers' minds.
In the UK, George Osborne has essentially hamstrung fiscal policy by turning it into a political hostage to fortune. And while no one on the MPC is voting to raise interest rates now, Adam Posen is still a lone voice in calling for further stimulus. Yet all the warning signals are there, both from financial markets and the recent economic data, particularly the Q2 growth figures. There is a real risk that policymakers manage to snatch recession from the jaws of recovery in the months ahead.