Recession Likely to Give Bond Yields a Pounding

A. GARY SHILLING <i> is president of A. Gary Shilling & Co., a Springfield, N.J.-based economic consulting firm</i>

Prices of high-quality U.S. bonds have been rising since late September, and the rally looks like the start of something really big. Within a year, the yields on long-term Treasury bonds, now about 8.2%, may reach the 4% to 5% range.

The two conditions for a substantial bond rally appear to have been met. First, the U.S. economy is far enough into a recession that everyone recognizes it, and is far enough into the downturn to subdue inflation. Even the inflation-fighting Federal Reserve has finally, begrudgingly, joined the recession camp and reluctantly eased credit a bit.

Although a big falloff in overall inflation rates has yet to occur, recent reports indicate that the economy is so weak that the surge in oil prices after the Iraqi invasion of Kuwait has not spread to other areas of the economy. Furthermore, most bond investors agree with me that after the Persian Gulf crisis is solved, by peaceful or military means, oil prices will fall significantly, and this decline may already be under way.

The second condition for a bond rally is a global recession. When the United States shifted from being the globe’s largest creditor to its largest debtor in the 1980s, we became dependent on foreigners to finance our federal deficit and our trade deficits. Declining confidence by foreign investors probably triggered the 1987 crash; foreign developments also had a lot to do with the rise in U.S. interest rates earlier this year, especially long-term rates. Consequently, U.S. bond yields were destined to remain high enough to attract foreign money and would not decline significantly until long-term interest rates fall globally. And that would take a global recession.


But now, other economies have followed the United States into recession, including all major English-speaking lands--the United Kingdom, Canada, Australia and New Zealand--and the remaining key economies will probably weaken soon. In response to softening economies and distressed financial markets, central banks--with the noted exception of the German Bundesbank--have started to push down short-term interest rates. Long-term rates have also started to fall in the United Kingdom and Japan, but such patterns have yet to develop in Canada, France, and of course, Germany.

Of course, it would be nice to see clear evidence of a global recession to ensure that a worldwide decline in long-term rates is under way, thereby removing the last obstacle to a big U.S. bond rally. But by the time such evidence is at hand, a fair amount of the bond rally will have been realized.

Furthermore, there is no assurance that this bond rally will continue without a nasty interruption or two. Given the collapse in the Tokyo stock market and the likelihood that the Japanese government has done just about everything it can to shore up that market, the possibility of wholesale selling of the sizable Japanese holdings of American stocks and bonds to reverse a collapse in their stock market could trigger further major corrections in U.S. security prices. There can be no assurance that U.S. Treasury bond yields wouldn’t spike, under these circumstances, up to 10% on their way to my forecast range of 4% to 5%.

The deeper and more global the recession, the bigger the decline in bond yields here and abroad. And, as we’ve discussed many, many times in recent years, this slump may be very severe indeed. As the economies of the world weaken, the exports and, therefore, the debt-repayment ability of Third World countries will dry up. Cash flow of many leveraged buyouts with huge junk bond interest payments will evaporate. U.S. real estate prices will drop further (much to the detriment of savings and loans, banks and insurance companies), and layoffs will make the excessive debts of many consumers excruciating.


Despite further bailouts by central banks and governments designed to preserve the integrity of financial systems, consumers, business and investors may see so many financial disasters coming so fast that they’ll ask, “Who’s next?” and their confidence will evaporate.

Furthermore, debt-laden consumers may be devastated not only by losing their jobs but also by the realization that the prices of their biggest assets, their houses, are continuing to fall. They would also be shocked if they were to learn the hard way that money market funds are not guaranteed as they assumed but contained the defaulting commercial paper and certificates of deposit of troubled banks. Loss of confidence, especially by consumers, whose spending accounts for two-thirds of economic activity, would greatly deepen the recession as measured by a real decline in gross national product and bring it in line with the already severe balance sheet recession.

In effect, the full fury of the balance sheet recession would be transferred to the income side. Then, the serious income statement and balance sheet recessions could reinforce each other as, for example, unemployed and worried consumers dumped houses on the market, thereby depressing prices and causing more distress for the real estate lenders.

A deep and global recession would easily reduce overall inflation to 2% or even less. Adding this to the normal 2% to 3% real, or inflation-adjusted, rates on Treasury bonds experienced in the earlier postwar eras, produces my 4% to 5% yield range. With lower inflation rates and the usual tendency of markets to overshoot equilibrium, even lower yields may be seen about a year from now in the depth of the recession.


Low yields, however, will probably be enjoyed only by high-quality bonds: Treasuries and highly rated corporate and municipal bonds in this country and similar bonds abroad. Junk bonds and issues that may be turned into junk by a severe recession have rallied lately but still seem destined for the scrap heap.

Nothing is ever certain, but I believe that what we called “the bond rally of a lifetime” in the mid-1980s has probably resumed. It may not quite be time to buy bonds blindly, but it probably is time to take advantage of a deepening U.S. recession and a budding global slump by moving funds into high-quality bonds in an orderly fashion.