As Trump touts stocks, bonds send an ominous message

President Trump often touts the buoyant stock market as an indication his economic policy success. In so doing, he chooses to ignore the much gloomier message that the bond market is now sending us as to where the U.S. economy might be headed.

Exclusively relying on the stock market as a measure of economic health could cost President Trump dearly in the run up to the 2020 election. This would especially seem to be the case considering how much more accurate an economic forecaster the bond market rather than the stock market has been.

The stock market has no track record of predicting economic recessions. The same, however, is decidedly not true of the bond market. Indeed, when long-term interest rates have remained consistently below short-term interests, they have accurately predicted each of the last nine U.S. economic recessions.

Choosing the right financial market on which to base one’s economic forecast is particularly important today when the stock market and the bond market are taking diametrically opposite views as to where the U.S. economy might be headed.

While U.S. stock markets are hitting new record highs and are partying like there is no tomorrow, the bond market is now signaling that real trouble might lie ahead for the U.S. economy.

A clear indication that the U.S. bond market is worried about the possibility of an economic recession is that U.S. long-term interest rates are significantly below short-term interest rates. Following a drop of more than 1 percent over the past year, 10-year U.S. Treasury bond yields recently dropped to below 2 percent, which is less than the Fed’s short-term interest rate target of 2.25-2.50 percent.

This so-called yield curve inversion implies that the bond market is expecting that, over the next year or so, the U.S. economy will weaken to such an extent that the Fed will be forced to make several interest rate cuts.

If the U.S. bond market is worried about where the U.S. economy is headed, the European bond markets are positively petrified as to where the European economy might be headed. As if to underline this point, a record $5 trillion, or around half, of European government bonds now offer negative interest rates.

As an example, one now has to pay the German government 0.35 percent a year for the privilege of lending it money for a 10-year period.   

To be sure, global bond markets are generally sensitive to economic risks. However, what seems to have them now on high alert is that this time around there are an unusually large number of such risks, especially in Europe, that have a high chance of materializing.

They also seem to be concerned that if these risks were to materialize, they would have the potential to destabilize both the U.S. and the global economies.

Among the more immediate of these risks is that the U.K. could soon crash out of the European Union. As if to underline this point, Boris Johnson, who is almost certain to become the U.K.’s next prime minister, is emphasizing that the U.K. will leave Europe with or without a Brexit deal on Oct. 31.

Were there indeed to be a hard Brexit, the U.K. economy is bound to shrink and the pound is almost certain to depreciate. That would almost certainly have important spillover effects to an already weak European economy.

A more serious, albeit less imminent, threat to the global economy is the risk that a fiscally irresponsible Italian populist government could precipitate another round of the Italian sovereign debt crisis.

With the Italian economy being approximately 10 times the size of that of Greece, an Italian debt crisis would pose an existential threat to the euro’s survival that would almost certainly reach our shores.

President Trump’s “America First” trade policy constitutes yet a further major source of risk to the global economy. Not only is the deterioration in U.S.-China trade relations already causing a significant economic slowdown in China, the world’s second-largest economy.

President Trump’s threat to slap a 25-percent import tariff on European automobiles sometime later this year could be the final straw that pushes an already ailing German economy into recession. 

In 2008, Queen Elizabeth asked why no one had forewarned her about the Great Recession. Should the U.S. economy succumb to an economic recession next year, President Trump will not be able to ask a similar question.

The U.S. bond market is now warning for all who might be bothered to listen that there is a very good chance of a US economic recession in 2020. 

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 market economic strategist at Salomon Smith Barney.