It sounds very arcane but of all the things that have been nagging away at the backs of the minds of professional investors, it has been the inversion of long and short interest rates in the US that has been the most worrying.
Why? Well, the natural state of affairs is for short rates to be lower than long ones for the simple reason that people committing funds for a long period will want a greater return than if they are doing so for a short one. When the reverse takes place something is up. It could be that long rates are artificially depressed for some reason. Or it could be that short rates have risen to a level that the markets consider unsustainable. Most usually, it is some sort of combination of factors, mostly disagreeable ones.
Thus, typically an inversion occurs when people think a recession is coming. If that were to occur, short-term interest rates would be cut by the central banks, thus correcting the relationship. But, of course, the relationship can be corrected by long rates going up, pushing up long-term borrowing costs and, particularly in the US, mortgage rates. Either would be bad news, which is why people sometimes argue that yield inversions are predictors of recessions.
Actually, I think that is misleading: it is too simplistic to claim inversions predict recessions. It is more correct simply to point out that they frequently occur in the run-up to one. At any rate, this situation serves as an antidote to the burst of exuberance currently evidenced in equities.
The best analysis of the uncertainties in the financial markets that I have seen comes from ING in a presentation called "There could be trouble ahead". The graphs above are taken from it. The thrust of its argument is that the markets are assuming that everything is going to turn out just fine and that therefore it is not prepared for the risks that lie ahead. This is not to say that there is a catastrophe out there; merely that risks are not being properly assessed.
The first two graphs encapsulate this Panglossian view of the world. GDP growth figures for the US, the eurozone and Japan have in the past five years been all over the place but the consensus projections for the future assume everything will carry on just nicely. In other words, the future will not be like the past.
The same goes for interest rates. Here, as you can see, expectations for sterling and dollar rates are more or less flat, euro rates will creep up a bit and yen rates will start to become real again. But this also is completely different from the past and you have to ponder whether this is reasonable. Since US bond yields (not shown) are also expected to stay around 5 per cent or a bit above, under this scenario the dollar yield curve will remain flat or slightly inverted for years to come. That is not normal.
Looking ahead, therefore, the markets see few risks but, as ING argues, there must surely be some risks ahead. It identifies six main ones.
One is the oil price. The market, having completely failed to call the present rise, now assumes there will be a plateau. But a sharp rise or indeed a sharp fall are possible.
A possible determinant of that, risk two, might be war in the Middle East, with Iran and Iraq as obvious flashpoints.
ING notes that changes at the helm of the Federal Reserve have in the past led to sharp changes in interest rates, risk three. I am not sure that this is likely now because the global inflation environment is more stable than it has been for half a century. If inflation is reasonably stable, interest rates are likely to be reasonably stable too. Still, it is a risk.
Risk four is China. The basic point here is that the Chinese economy, while still only a little larger than the UK, is growing so fast as to be a source of potential instability. In particular industries, it is tremendously important. It is the world's second largest consumer of oil, consumes half the world's cement and produces two-thirds of the world's photocopiers.
Then there is bird flu and Sars, with the economic disruption of Sars as a proxy for what bird flu might do, with the disruption running ahead of the actual disease - risk five.
Finally there are national risks, of which the most obvious and, I would have thought, the only one with potential global consequences is the possibility of a US housing crash. So let's list that as risk six.
My own instinct here is that were US house prices to become really wobbly, the Fed would cut interest rates by enough to signal that it would not permit a crash. In effect, that is what the Bank of England did last summer, ending the crisis of confidence that struck the housing market for the first six months of last year. But there is a risk - and, incidentally, I would be a bit cautious of the current evident revival in UK prices, which may not be sustained. The risks both to the economy, and hence on interest rates, must surely remain on the downside.
If that all sounds a bit dismal, it is important to put it in context. There is such a thing as the business cycle. The final graph shows the rate of change of the OECD leading indicator, one measure of that cycle. As you can see, it does not show the cycle as such, rather an early indication of possible turning points in it. Thus the peak in 1999 and that long slide down through to 2001 shows the swing from boom to bust. The sharp climb in the US indicator two to three years ago gave an early signal that the US growth would outperform in the past couple of years. However, the fall since then has not as yet been reflected in any slowing and now all the lines are heading up again.
My interpretation of all this is that the present growth phase still has some way to run, which of course is consistent with the strong tone of financial markets. But I do think it is worth remembering that while the business cycle may be less marked than it used to be, it does still exist. Something will end this growth phase, perhaps one or more of the usual suspects listed above. The trouble is that it is possible to identify the cycle only in retrospect - and trends once established do tend to carry on for longer than everyone expects.
So the alarm that some people read into the interest rate inversion may be just that. What really is not credible, however, are those "steady as she goes" predictions of economic growth and interest rates in the first two graphs.
So the champagne may well keep flowing awhile yet. But the point about risk is that it has to be correctly priced. Just as there have been periods in the past when all of us - as consumers, investors, employees - have been too worried, there are also periods where we are not worried enough.Reuse content