Bond Market: Why Is Everything Upside Down?
Recently, the bond market flipped upside down—raising recession fears, unnerving investors and driving stock markets to one of their worst days all year. What’s going on?
Bond yields in major developed countries declined sharply in mid-August, bringing the total amount of negative-yielding bonds around the globe to more than $16 trillion. The entire German yield curve is below zero. In the U.S., the 30-year Treasury yield fell below 2% for the first time in history, causing the yield spread between two-year/10-year Treasuries to invert briefly, for the first time since 2007. The three-month/10-year spread has been inverted on and off since March.
Because yield curve inversions have preceded every U.S. recession in modern history (although in some cases an inversion has sent a false signal), the state of the yield curve triggered recession fears, driving stocks sharply lower.
30-year Treasury bond yields dipped below 2% for the first time ever in August
Source: Bloomberg, daily data as of 08/15/2019. Past performance is no guarantee of future results.
It isn’t supposed to work this way. Negative interest rates—especially at the long end of the yield curve—are a new phenomenon. Bonds shouldn’t have negative yields. You don’t pay a borrower to take a loan from you. Not only should bond yields be positive, but longer-term bonds should have higher yields than short-term bonds—that’s a “normal” yield curve. Investors usually demand a risk premium to compensate for tying up their money for a longer period of time. Inverted yields, besides being abnormal, also tend to occur when the Federal Reserve has been tightening policy aggressively to quell inflation—not when it is easing rates, as it has done recently.
While many of the questions investors are asking have no easy answers, here are a few thoughts on some of the most common concerns:
1. Why are bond yields negative in so many countries?
Negative-yielding bonds are the result of both short- and long-term factors. Short-term factors include:
- Slowing global growth compounded by the U.S.-China trade war. Europe is on the cusp of recession, with the manufacturing sector already in contraction in Germany, its largest economy. China’s industrial production growth rate has slowed to a 17-year low amid a falling demand for manufactured goods, while its credit growth has slowed to a crawl.
- Fears that the trade war will last a long time. A protracted trade war could weigh on global growth and potentially pull the U.S. into a recession.
- Negative policy rates in many countries. The European Central Bank (ECB), the Swiss National Bank, the Bank of Japan (BOJ) and others have pushed short-term rates to zero or below in an effort to stimulate lending and economic growth. It’s notable that more than 40% of the negative-yielding bonds are in Japan, with the rest European in origin.
- Large central bank balance sheets have reduced the supply of bonds available to the market. The Fed has reduced its balance sheet, but only by about $650 million from a peak level of $4.5 trillion, and will soon hold it steady. The ECB has bought up much of the supply on the market, and issuance is low because budgets aren’t expanding. The BOJ largely buys whatever bonds are issued.
Central bank asset holdings as percent of gross domestic product
Sources: Bloomberg. Federal Reserve (BSPGCPUS), European Central Bank (9BSPGCPEU), Bank of Japan (BSPGCPJP), Bank of England (BSPGCPGB). Monthly data as of 7/31/2019.
Then there are the long-term factors, the ones that affect the term premium* (as “term premium” isn’t a phrase you typically hear in daily conversation, I’ve included a review of the concept below). These long-term factors include:
- Aging populations in developed countries, leading to rising demand for income-generating investments, like bonds.
- Markets don’t believe central banks will be able to raise policy rates much or at all over the long run, due to slow growth, low inflation, and an overhang of debt.
- Deflation or “Japanification” fears. Japan has spent the past few decades fighting deflation due to an aging and declining population, and slow growth due to too much debt. Some economists fear other advanced economies could fall into the same long-term rut.
- Strong demand for long duration, safe assets by insurance companies and pension funds that need assets to match up with their liabilities.
2. Who in the world would buy negative-yielding bonds?
- Institutions: As mentioned above, pension funds and insurance companies need long-term assets to offset long-term liabilities to aging populations. As long-term bond yields fall at a faster rate, these investors are forced to chase the yield lower, sending prices—which move inversely to yields—higher.
- Banks: Regulations require banks to hold government bonds as part of their capital buffer against loan or trading losses.
- Speculators and/or deflationists: For investors who expect bond prices to continue rising, it doesn’t matter if the yield is negative. Deflationists expect bond prices to move higher.
- Safe-haven seekers: Investors who are looking for safety or a hedge against a decline in equities appear willing to pay a price in the form of a small negative yield. This is occurring outside the U.S., where short-term rates are more negative than long-term yields. In the U.S., cash and cash-equivalent investments (such as Treasury bills or money market funds) still offer a decent yield.
- Central banks: Central banks are indifferent to price or yield during quantitative easing programs.
3. Does the inverted yield curve mean there is a recession coming soon?
- Not necessarily, but it does signal that the risk of recession is rising. An inverted yield has been a reliable indicator of recession. Every recession in modern history has been preceded by an inverted yield curve. However, not every inversion has led to a recession in the next one to two years; there have been a few false signals.
- “It’s different this time.” Those are the four most dangerous words in finance, but every cycle is unique. In this cycle, the unusual feature is that the inversion of the yield curve is being led by the steep drop in long-term rates rather than a sharp rise in the short-term federal funds rate. Although the Fed probably went too far with the rate hikes last year, the economy is still posting trend growth of around 2% to 2.5% or so, and credit still seems to be flowing freely to consumers and businesses at reasonable rates and generally on easy terms.
- Flat or inverted yield curves may be the new normal. If the term premium* remains in negative territory for an extended period of time, it is much more likely that the yield curve will tend to be flat or inverted more frequently. The longer-term drivers of the negative term premium suggest that long-term yields may not have that much upside. Consequently, cyclical upswings in growth that push short-term rates higher could mean extended periods of time with the yield curve flat or inverted.
- Recession is a risk. Nonetheless, with the global economy weakening and the trade war at a standoff, investors are wise to be cautious.
Treasury yield curve—a lot has changed
Sources: U.S. Treasury, Bloomberg. Data as of 8/19/2019 (current), 7/19/2019 (month ago) and 8/20/2018 (year ago).
4. What would turn the bond market right side up?
- A lasting trade deal between the U.S. and China that removed tariffs and resolved longer-term issues about intellectual property rights would likely send bond yields higher. It probably would provide a welcome boost to business confidence and investment in the U.S. and globally.
- Fiscal stimulus outside the U.S. There has been some speculation that Germany is considering increased government stimulus to boost growth, as it has a budget surplus. There are also hints that China will shift policy to ease financing provisions to small businesses.
- Inflation. Recent Consumer Price Index and wage growth readings suggest news of the death of inflation may be premature. Inflation is still quite low, but there are hints that it is picking up. Unit labor costs are accelerating and the velocity of money1 has been rising—two indicators that could mean more inflation in the next one to two years than expected.
Sources: Federal Reserve Bank of St. Louis (FRED), Bloomberg. Inflation indicators: PCE Deflator = U.S. Personal Consumption Expenditure Deflator; Core PCE = U.S. Personal Consumption Expenditure Core Price Index; Overall CPI = Consumer Price Index for All Urban Consumers: All Items; Core CPI = Consumer Price Index for All Urban Consumers: All Items Less Food and Energy; FRBA Sticky Price CPI Core = Federal Reserve Bank of Atlanta Sticky Price Consumer Price Index, Less Food and Energy; FRBA Sticky Price CPI = Federal Reserve Bank of Atlanta Sticky Price Consumer Price Index; FRBC Trimmed-Mean CPI = Federal Reserve Bank of Cleveland 16% Trimmed-Mean Consumer Price Index % change at annual rate; FRBC Median CPI = Federal Reserve Bank of Cleveland Median Consumer Price Index % change at annual rate. Monthly data as of 7/31/2019.
5. What should I do now?
- Focus on higher credit quality. We continue to suggest staying up in credit quality. With the economy growing at a slow pace and yield spreads versus Treasuries relatively low, the risks are rising that lower-rated bonds could be downgraded or could default.
- Consider adding intermediate- to longer-term bonds when yields rise. Despite the declining trend in Treasury yields, we believe investors should not abandon their longer-term bond holdings. With the potential for short-term rates to fall even further, intermediate- and longer-term bonds allow investors to lock in yields, and provide diversification benefits in case yields do continue to drop. While “chasing the market” isn’t a good idea, consider periods when yields rise as an opportunity to add longer-duration securities. We also continue to suggest as strategies to consider in the current environment.
- Stay diversified. When markets become volatile, the benefits of diversification become more visible. Fixed income securities, particularly U.S. Treasuries, historically have provided a good counterbalance against a decline in stock prices. Don’t just focus on nominal performance—pay attention to risk-adjusted returns.
Treasuries historically have provided the best “hedge” against a decline in stock prices.
Note: Correlation is a statistical measure of how two investment have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500® index during the five-year period between August 2014 and August 2019. Source: Bloomberg, using weekly total returns data as of 8/16/2019. Past performance is no guarantee of future results.
* Term Premium: A Brief Review
The term premium is the extra yield investors demand to tie up their money for a long time period versus just holding short-term investments. To understand it, start with the equation that describes how bond yields are determined: Bond yields = the weighted average of short-term interest rates + a term premium.
As an example, an investor with a 10-year time horizon can buy either a 10-year bond or a series of short-term bonds over the course of 10 years. In other words, you have a choice of rolling over T-bills for a decade, or just buying the 10-year note.
To decide which is better, you can look at what the market expects short-term interest rates to do over the next 10 years, and compare that to the current yield on the 10-year note. (The expected path of short-term rates is found in the “forward curve”). Normally, the yield of the 10-year note will be higher than the weighted average of what the market is pricing into the path of short-term rates. That’s because there is a risk that the path of short-term rates will diverge from what’s priced into market expectations.
Consequently, most investors will demand a higher yield to compensate for the chance that short-term rates will move up faster than what is priced into the market. Historically, when there is a divergence between the forward curve and the actual path of short-term rates, it has usually been due to inflation rising faster than anticipated, leading to higher short-term rates. If the risk premium isn’t big enough, the investor who chose bonds instead of rolling over T-bills will have underperformed. So inflation expectations play an important role in the term premium. Other factors do as well—prospects for supply and demand based on demographics and investor preferences.
1 The velocity of money is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.