What the Global Bond Market Is Telling Us: A tale of two markets.

• Author: Lachman, Desmond

It is not often that the global sovereign bond market and the global risk markets have held as divergent a view as to the world economic outlook as they have done in recent months. This could portend real trouble ahead for world financial markets and the global economy.

While global sovereign bond markets, along with the world's central banks, are now signaling that real trouble might lie ahead for the U.S. and global economies, global equity and credit risk markets have continued to party like there was no tomorrow.

Considering that the sovereign bond market is generally a very much more accurate forecaster of economic recessions than are the equity and credit risk markets, financial market regulators should be asking themselves whether the global financial system is sufficiently robust to withstand a sharp repricing of global risk in the year immediately ahead.

A clear sign that global equity markets entertain a rosy view as to the world economic outlook is the historically high valuations at which these markets have been trading. In the case of the United States, today's high equity valuations have only been experienced on three occasions in the past one hundred years.

A clear sign that global credit risk markets think the world economy's skies will remain forever blue is their very tight spreads with respect to the risk-free alternatives. An indication of this optimism is the fact that credit spreads on U.S. high-yield debt and on emerging market debt with respect to U.S. Treasury bond yields have remained at close to their pre-2008 economic crisis lows.

The global sovereign bond markets are telling a very much gloomier story as to where the world economy might be headed. One indication of this has been the recent marked inversion of the U.S. yield curve. This inversion would imply that the U.S. bond market expects that generalized U.S. economic weakening will force the Federal Reserve to aggressively cut interest rates.

A more dramatic indication of sovereign bond market pessimism is the fact that a record US$13 trillion of global sovereign bonds, and around one half of all European sovereign bonds, offer negative interest rates. This would imply that these bond markets are expecting that gloomy global economic conditions will keep inflation down at an unusually low level for the indefinite future.

To be sure, bond markets and the world's central banks are generally sensitive to economic and political risks. However, what seems to have...