Warning signals of a double-dip recession flash brightly across the world
Global bond markets are flashing warning signals of a sharp slowdown in growth across the world and a possible slide toward a double-dip recession and outright deflation.
By Ambrose Evans-Pritchard
29 Jun 2010
The yield on two-year US Treasuries has fallen to a record low of 0.61pc in a flight to safety, a level not seen during the depths of the Great Depression. Ten-year yields dropped below the psychologically sensitive level of 2.96pc.
Such levels are clearly incompatible with assumptions on Wall Street for 3pc growth in the second half of this year. “If the bond market is correct then this recovery could be dead in the water,” said Jim Reid, credit strategist at Deutsche Bank. The credit markets tend to sniff out trouble first and have acted as an early warning alert at every stage of the financial crisis over the past three years.
Mr Reid said deflation has emerged as the dominant risk in the West and will force central banks to renew quantitative easing, the Americans “pre-emptively” and the Europeans “only when their backs are against the world”.
Triple tremors from the banking crisis in Spain, crumbling confidence in the US, and a setback in China’s leading economic indicator all combined with a vengeance on Tuesday. “The market in risky assets has capitulated today amid fears that the global recovery is petering out,” said Gavan Nolan, head of credit at Markit.
Rumbling in the background are influential voices warning of a global slide into economic quagmire. Nobel Laureate Paul Krugman said premature tightening in much of the North Atlantic region at the same time would lead to disaster. “We are now, I fear, in the early stages of a third depression, primarily a failure of policy. Both the United States and Europe are well on their way toward Japan-style deflationary traps. The Fed seems aware of these deflationary risks, but what it proposes to do is, well, nothing,” he wrote.
China’s Shanghai composite index of equities fell 4pc on Tuesday and is now 55pc below its peak in late 2008. The authorities have been tightening this year to slow inflation and curb property speculation as home prices in Shanghai and Beijing reach 13 times incomes, but it is unclear whether they can engineer a soft-landing in an economy where state-owned banks have built up huge hidden debts.
The Baltic Dry Index that measures freight rates for bulk goods – and watched as a proxy for the ups and downs of the Chinese economy – has dropped by 40pc over the past month.
In Europe, investors remain jittery as the European Central Bank prepares to shut its emergency facility of €442bn (£361bn) of one-year loans, the largest sum ever lent by a central bank.
A report in the Financial Times that Spanish banks have been begging the ECB to extend the one-year scheme has heightened fears that they are totally shut out of the interbank markets. The shares of BBVA fell 7pc and Santander fell 7pc.
The ECB is offering a three-month tender on Wednesday, which will indicate how many banks are under strain. Hans Redeker, curency chief at BNP Paribas, said this facility is unlikely to reassure the markets. “This just builds up a tidal wave of short-term funding needs that all need to be rolled over at the same time,” he said.
The Spanish cajas or savings banks are clearly in trouble, relying on the ECB for 21pc of their funding. There were signs of an incipient run on Spanish banks on May 7, an episode described by ECB president Jean-Claude Trichet as perhaps the most serious crisis since the First World War. These pressures linger. The Spanish daily Expansion reports that the Bank of Spain has ordered inspectors to track capital flows abroad after the haemorrhage of €18bn in the first half of the year, mostly to accounts in Switzerland, Luxembourg and Ireland.
“Foreign capital flight is under way. This can only make matters worse given the climate of insecurity and the country’s lack of credibility,” said Borja Duran from Wealth Solutions in Madrid.
The latest twist is a rise in credit default swaps on Italian debt, which jumped 16 basis points to 203 yesterday. An auction of Italian bonds this week went badly, with low bid-to-cover ratios.
The Bank of New York Mellon said its flow data had picked up a relentless flight from both Greek and Italian debt. It is clear evidence that the EU’s €750bn shield with the IMF for eurozone debtors has failed to restore the confidence of global investors, who fear that the EU’s austerity strategy risks setting off a self-defeating downward spiral.
Spreads on Greek debt have jumped 350 basis points since the EU announced its plan in early May. Portuguese and Spanish yields have both jumped sharply despite direct action by the European Central Bank to force down yields. Private buyers are clearly dumping their holdings onto the ECB as fast they can.
Mr Redeker said Japanese life insurers and institutional investors are slashing their estimated $700bn holdings of European debt. The funds are being recycled into yen, which reached ¥107 against the euro yesterday, the strongest in nine years.
The flight to safety in Tokyo depressed yields on Japanese 10-year bonds to 1.11pc. There are concerns in any case that Japan itself may be sliding back into deflationary deep freeze. Japan’s unemployment rose in May for the third straight month to 5.2pc. Industrial output fell slightly. Production of capital goods – a leading indicator – fell 4.4pc.
Italy has been largely immune to Europe’s bond crisis until now, thanks to high savings. None of its banks have required a rescue. However, fresh threats of secession by the Lega Nord and last week’s general strike over austerity measures have revived fears about the stability of the political system.
Italy’s public debt is the third largest in the world after the US and Japan. Everybody knows that if the crisis ever reaches Rome, the game is up for monetary union.