Global Growth Outlook for 2020

Cutting through the noise by taking an average of the 23 correlations, on balance, the slope of the yield curve, correlation with future growth peaks three to five quarters in advance.  In other words, a steepening of the yield curve today might translate into stronger growth about six to 15 months later.  A flatter yield curve implies slower growth about half-a-year to a year-and-a-quarter in the future (Figure 2).  At the same time, we don’t wish to overstate the significance of these findings.  In many cases the correlations are not particularly strong.  Moreover, as the late 1990s demonstrated in the US, under certain circumstances, such as a soaring equity market, the economy can defy a flat yield curve and grow anyway. 

The good news is that yield curves have shown themselves to be useful, if imperfect, indicators of the direction of the various economies in the past.  The not so great news is that of the 23 yield curves that we examined, 18 of them are pointing towards slower growth. 

To reduce a large and complicated data set into a single bite-size piece, we examined, relative to their own respective histories, how steep or flat each of the 23 yield curves have been on average in October and November 2019.  If the curve was the steepest it’s ever been, it would have a value of 100%; if it was at its historical flattest, it would have a value of zero. Only five curves, Brazil (BRL), Chile (CLP), China (CNH), India (INR) and South Africa (ZAR) have been steeper-than-average, pointing towards stronger growth.  In each of these five countries, central banks have been easing policy.  The People’s Bank of China has been slashing its reserve requirement ratio.  The others have been cutting interest rates.  The results have been the same: steeper yield curves and the possibility of stronger growth. 

By contrast, the other 18 yield curves have all been less steep than their historical averages, in some cases dramatically so.  For the eurozone (EUR), Israel (ILS), Japan (JPY), Mexico (MXN), Thailand (THB) and the United States (USD), yield curves are all in the bottom 10% of their historical steepness, pointing towards the likelihood of sharply slower growth ahead.  It’s especially striking that Mexico and the US are in this boat, since their respective central banks have both cut rates three times.  Most of the others, including those in Australia (AUD), Canada (CAD), South Korea (KRW), Norway (NOK), Poland (PLN), Sweden (SEK), Switzerland (CHF), Turkey (TRL) and the UK (GBP) are in the bottom third of their historical steepness, pointing towards the likelihood of somewhat slower growth ahead in 2020 and 2021 (Figure 3).  Russian (RUB) and Colombian (COP) yield curves have a more neutral footing relative to their respective histories.

On a GDP-weighted basis, the five countries that seem most likely to accelerate account for $19.5 trillion in 2019 GDP, according to the IMF, or about 25% of the total GDP represented by these 23 currency areas.  The other 75% ($57.9 trillion), looks set to slow, at least if past correlations hold in the near future.  That said, if global interest rate markets are correct, and China as well as India, see a rebound in growth, that could be great news for commodity prices and emerging market currencies.  China alone accounts for 40-50% of the demand for industrial metals like copper and exerts a strong influence on energy and agricultural markets as well as the fortunes of the world’s commodity exporters.

Before throwing in the towel on global growth, however, its worth asking at least a few questions:

1. Are flat yield curves in places like Europe, Japan and even the US, a distortion caused by QE?
2. Do negative deposit rates in Europe and Japan also distort the analysis?
3. Could soaring equity markets offset tight credit conditions in fixed income markets?
4. How confident should we be in this analysis from a statistical perspective?  Does it vary by currency?

The idea that the Federal Reserve’s (Fed) QE still distorts the yield curve is a hard case to argue.  For starters, the Fed stopped expanding its balance sheet in late 2014.  Secondly, it began passively shrinking its balance sheet in late 2017, reducing it from 25% to 18% of GDP.  Since September it has provided some liquidity to the repo market but is careful to distinguish these actions from a renewed embrace of QE.  Any remaining distortion from QE is probably small, especially given the explosive increase in Treasury debt issuance as the US budget deficit has spiraled from 2.2% to 4.7% of GDP over the past three years.

By contrast, the European Central Bank (ECB) has inaugurated another round of QE and neither the ECB nor the Bank of Japan (BoJ) ever shrank their balance sheets after previous rounds of QE.  One could argue that the extreme sizes of the QE’s (44% of eurozone GDP and 100% of Japanese GDP) distorted interest rate markets and artificially flattened yield curves – both at home and in markets abroad, including in the US.  This is undoubtedly true.

Likewise, negative rates in Europe and Japan rather than boosting economic growth appear to be holding it back while quantitative easing appeared to have little effect either way.  Negative rates may indeed be distorting yield curves as well.  That said, if negative rates are holding back growth in Europe and Japan, that is consistent with their yield curves being flat.  As such, flat yield curves in Europe, Japan, and even the US, might be accurately gauging the failure of QE and negative rates to stimulate growth, just as they may have accurately evaluated the potentially negative impact of so much Fed tightening.  The difference between the Fed’s 2015-18 tightening cycle and the ECB and BoJ’s experiments with negative rates is that the Fed meant to tighten policy.  The ECB and the BoJ tried to loosen policy but, by all appearances, accidentally tightened policy instead by imposing a negative interest rate tax on banks and savers.  As such, it’s not overwhelmingly clear that flat yield curves are really sending bad signals, at least in the case of Europe.

In terms of how much confidence one should place in the yield curves, the answer varies by country and currency.  Of the 23 currencies, Chile, China, Sweden and South Korea demonstrated the strongest relationships between yield curve shape and subsequent GDP growth, followed by Colombia, Canada, Turkey, Mexico, India, the eurozone, New Zealand, and Norway.  That eurozone growth had an above-average correlation between 3M10Y and subsequent GDP growth is impressive given the degree of the ECB’s QE and the existence of negative rates for one quarter of the eurozone’s history as a currency bloc. 

The weakest relationship, however, was Japan, where the BoJ did a QE that was in order of magnitude bigger than what the Fed or the ECB did.  In addition to buying far more bonds relative to the size of GDP, the BoJ also went down much further in terms of credit quality.  Unlike the Fed it didn’t limit itself to government bonds and AAA-rated mortgages.  It went for corporate debt as well and even equity-ETFs. Japan has also spent longer at zero rates than any other country and, unlike, Europe and US, experienced long-term deflation that has only been corrected during the past few years.

Also, unlike the Fed and the ECB, the BoJ’s QE actually did work.  Japan returned to growth and deflation flipped, becoming inflation for the first time in decades.  Japan’s distorted yield curve signaled none of this.  Perhaps Japan’s currently flat yield curve also isn’t really signaling a slowdown either.

Japan was followed by Israel, Brazil, South Africa, the US, UK, Poland, Australia, Thailand and Russia among the weaker relationships between 3M10Y and future GDP growth.  Switzerland was right in the middle of the pack.  You can’t count on much in life, but you can always count on the Swiss to be neutral.

That India and China, which demonstrated among the strongest relationship between yield curve slope and subsequent GDP growth, have relatively steep curves is encouraging.  Likewise, the fact that the flatter curves are in places like Israel, Japan, eurozone and the USA, which have shown weaker relationships between yield curve slope and subsequent GDP growth, may also be encouraging.  At any rate, the next few years will provide yet another test of whether or not yield curves do an accurate job of forecasting growth.

For the details of each market as well as the exact Bloomberg codes for each currency/country, please see the Appendix. 

Bottom line

• Yield curves are pointing to stronger growth in China, India, Chile and Brazil.
• Yield curves are pointing towards sharp slowdowns in the US, eurozone, Japan and Israel.
• All 23 yield curves examined have a positive correlation with growth 3-5 quarters in the future.
• There is a wide variance in the forecasting accuracy among the yield curves.