By Erik Norland
In the United States, one factor appears to do a better job of forecasting economic downturns than any other: the shape of the yield curve. Over the past 40 years, there have been five sustained yield-curve inversions – when long-term interest rates are lower than short-term rates -- and each one presaged a recession and a significant rise in unemployment (Figure 1). The good news is that despite the Federal Reserve (Fed) raising interest rates four times since December 2015, the U.S. yield curve is nowhere near to signaling a recession. Ten-year yields still exceed two-year yields by nearly 100 basis points (bps).
Across the Pacific Ocean, China’s yield curve is telling a starkly different story. After inverting in May and June, its yield curve remains extremely flat and may be signaling an impending slowdown in the world’s second largest economy (Figure 2). Yield curves are useful but are by no means perfect indicators of economic downturns and should always be taken with a grain of salt. The question is, how big of a grain of salt when it comes to China’s yield curve?
For starters, in contrast to the United States, debt capital markets are relatively new to China. They are also less free from government control and are neither as deeply liquid nor as sophisticated as their U.S. counterparts. Secondly, China hasn’t experienced a recession in decades. With those two caveats made, China’s yield curve has, over the past decade, done a decent job of anticipating economic acceleration and slowdowns in its pace of growth. For example, a sharp flatting in the three-year to 10-year (3Y-10Y) spreads in late 2007 anticipated the abrupt 2008 financial-crisis-era slowdown in China’s growth rate from more than 14% to just above 6%. Likewise, a massive late-2008 upward steepening in the curve presaged a return to double-digit growth that lasted from mid-2009 until early 2012. A subsequent flattening of China’s yield curve in late 2010 through mid-2012 appeared to lead the country towards slower, sub-7% rates of economic growth. And, a slight steepening of the curve in 2016 came ahead of a minor uptick in China’s growth.
The correlation between China’s 3Y-10Y yield curve slope and the change in GDP growth is quite strong, especially when comparing the yield curve to GDP growth four to five quarters in the future (Figure 3). As such, China’s currently very flat yield curve is strongly suggestive of a major slowdown that could occur in mid-2018.
We don’t know if the most recent flattening wave in China’s yield curve is correctly pointing to the slower economic growth ahead. The performance of China’s GDP in the coming quarters should give us more information regarding the veracity of this indicator. What we do know with certainty is that commodity markets and currencies that are sensitive to the pace of China’s economic growth don’t appear to be the least bit concerned by the recent flattening in its yield curve. Copper prices, for example, which appears to follow rather than lead Chinese GDP, climbed to their highest level in two-and-a-half years partly because of China banning imports of scrap metal (Figure 4). The same can be said of iron ore and the currencies of its two biggest exporters, Australia and Brazil (Figures 5 and 6).
The question of China’s yield curve and its usefulness in forecasting acceleration and slowdowns in China’s pace of economic growth takes on added urgency given the country’s colossal debt. Prior to the 2008 financial crisis, China’s ratio of public and private debt to GDP was below 150%, far below the ratios in the United States and Europe (Figure 7). In response to the financial crisis, China’s central bank, the People’s Bank of China (PBOC), cut rates (Figure 8), steepening the yield curve and encouraging a massive levering up that boosted economic growth rates back into the double digits. Today, China’s total debt levels are nearly 260% of GDP and exceed those in the United States and Europe where interest rates are much lower.
This doesn’t mean that China’s economy is in danger of an imminent slowdown. One difference between China today and the Europe and the United States of a decade ago is that back then the European Central Bank and the Federal Reserve had just completed significant tightening cycles which helped to prick their debt bubbles and bring about the financial crisis. By contrast, the PBOC has left monetary policy unchanged for the past two years after a 2014-15 easing cycle. Does a bull flatten in a yield curve send the same economic signal as a bear flattening? Time will tell. Even so, the recent crackdown on lending growth in China might be the reason why the yield curve has flattened, and cutting off credit growth might eventually imperil both Chinese growth and the recent rebound in copper, iron ore and the various commodity currencies.
- Despite its imperfections, yield curve in China has been useful in signaling acceleration and slowdowns in economic growth over the past decade.
- China’s yield curve is signaling a coming slowdown in China’s economy that could be exacerbated by China’s high level of leverage.
- The slowdown may most likely occur in mid-to-late 2018, although it could start earlier or later than that timeframe.
- In contrast with the Fed and ECB in 2007/2008, the PBOC is coming off an easing, rather than a tightening, cycle.
- Does a bull flattening of the yield curve send the same signal as a bear flattening?
- China’s crackdown on credit expansion may be the reason why the yield curve has flattened and, if so, could spell trouble for China’s economic growth.
- Commodity markets such as copper and iron ore, as well as commodity currencies, appear to be looking backwards at China’s recent GDP growth rather than looking forward to the possibility of renewed economic slowdown.