The bond market has entered a financial twilight zone, and at this point, there doesn’t seem to be a smooth way out.
For the last several weeks, investors have been watching a swift move lower in global bond yields — with the amount of negative yielding debt increasing to the point where it now equals nearly a third of tradeable bonds worldwide, according to J.P. Morgan.
Investors have jumped into the safety of bonds, amid worries the global economy is slowing and that the trade wars will take a bigger toll on growth. Yields are also cascading lower, as global central banks rush to cut interest rates, a factor feeding the downward spiral in yields.
That doesn’t mean U.S. Treasury yields will also go negative with the other $15 trillion in negative yielding debt. But some strategists say they could, and at the very least Treasurys should continue to see new low rates as European and other negative yields hit new lows. Yields move opposite price, so in an extremely low yield or negative world, investors hope for price appreciation on instruments where they had once looked for yield.
“It’s very depressing…Just think about it as a saver or investor,” said Michael Schumacher, director rates at Wells Fargo. “It’s very hard to wrap your arms around the idea of negative yields. It doesn’t really sit well…It’s terrible for the financial system. Look how European banks have done for the last six, seven years—very poorly.”
As rates drop around the world, the U.S. has become an even more attractive market, for the remaining yield it has and the fact the economy is growing. Contrast that to Germany where its economy is shrinking and the 10-year bund is yielding a negative 0.69%, compared to the U.S. 10-year yield, at 1.54%.
Disorderly and painful
Strategists say the reversal of the bond market trade could be disorderly and painful if it happens quickly.
J.P. Morgan strategists point out that four countries — Denmark, Germany, Netherlands and Finland — now have negative yields across their full spectrum of rates.
“In our conversations with clients, the experiments of central banks with negative rates are viewed more as a policy mistake rather than stimulus and create a sense of an abnormal and uncertain environment that damages not only banks but also consumer and business confidence,” the J.P. Morgan strategists wrote.
The Federal Reserve is expected to cut rates again in September and possibly later, triggering lower interest rates around the world. The differentials between global interest rates is putting pressure on currency moves.
“I think the momentum trade is basically saying to the Fed: ‘You’re falling behind the curve.’ The Fed does need to keep up with what’s going on in global markets. The one barometer we have to look at, to make it simple, is the dollar. The stronger the dollar gets, the more negative it is for the global economy,” said Jim Caron, portfolio manager at Morgan Stanley Investment Management. “A lot of the world’s debt is in dollars. The slower the Fed goes, the stronger the dollar gets.”
Caron said investors continue to buy bonds for performance, and they are finding it as rates continue to drop. “People are getting socialized to lower yields…It’s bizarre,” said Caron. “It could definitely stay like that for awhile.”
Positioning in the bond market has become so extreme that the rules are being thrown out, and the spiral lower is feeding on itself. U.S. yields are going down as investors that need to hold long term securities move into the long end of the Treasury curve.
“I think the main driver right now is basically the lack of foreign yields…Tomorrow, Germany is going to issue a 30-year bond. It’s going to have a zero coupon, but it’s probably going to come at a premium,” said Hans Mikkelsen, head of investment grade corporate strategy at Bank of America Merrill Lynch. “The existing 30-year debt is trading at negative 0.18%.”
The move lower in foreign sovereigns has spilled over to the Treasury market. The U.S. 30-year bond hit a low yield last week of 1.916%, and the 10-year could revisit the low of 1.32% it hit in July, 2016, after the U.K. voted to leave the European Union. Some strategists expect to see the 10-year at a new record of 1.25% by year end.
“This growing universe of negatively yielding bonds is becoming self-reinforcing as certain investors such as insurance companies and pension funds rush to avoid locking in negative yields to maturity,” noted JP Morgan strategists. “There is little doubt that negative yields are causing a distortion in the pricing of duration and credit risk as pension funds and insurance companies are forced to move further up the maturity and credit curve to avoid negative yields.”
Analysts say the sharply lower U.S. Treasury yields could snap back if the trade war between China and the U.S. is resolved.
“I think where it has to stop is wherever the market believes there’s stimulus or some potential for growth,” said Caron. “The headwinds to global growth are being generated by concerns about trade.” He said there could be a reversal if the headwinds go away. “Or if there’s a recession, we’re priced for it.”
Mikkelsen said there are other scenarios besides trade, that could bring about a reversal in the move that has driven foreign investors into U.S. corporate bonds, as well as Treasurys. “Maybe central banks are successful, and they create inflation. That’s kind of what they’re trying to do,” he said.
If investors suddenly find fixed income less attractive, that could cause problems. “I think that could be very disorderly. There’s no sign of it, but that is one of the risks,” he said.
Schumacher said a reversal in yields could ultimately be more broadly positive for the economy and financial markets.
“If super secure government bonds are in a bubble, and that burst that might be a positive for the financial system and the global economy,” said Schumacher. “If you’re positioned the wrong way, you’re going to take a hit. About the whole trade thing, the timeline could easily extend into 2020.” He said it could be “bloody” but better for the financial system.
Schumacher said it’s unlikely the U.S. could see negative yields but they could go lower in some scenarios. “To some degree, it becomes self-fulfilling,” he said. “Imagine a scenario where trade doesn’t get any better. It doesn’t get much worse and it’s kind of going on in the background. Brexit is going on and you see yields could grind lower but we could easily wake up in a month and find the U.S. 10-year is not at 1.55% but it’s 1.30% and the yield curve could be more inverted., and that’s not a good thing. If someone plays hard ball on trade. Yields could drop a lot more.”