Negative Yields Run Rampant

February 5th, 2016 7:40 am | by John Jansen |

Via the FT:


Government bond yields send recession signal

Universe of negative yielding debt grows beyond $5tn as central banks indicate further easing

If major government bond markets are right, the global economy is sliding towards recession and central bank easing policies will pull borrowing rates deeper into negative territory.

In Germany, the average yield on all government debt is now negative, while Japan is on course to become the first major bond market with a 10 year bond that yields nothing. In Europe and Japan, government bonds worth nearly $6tn now trade at such highs that buyers will make a loss if they hold the paper to maturity.

Across the Atlantic, talk of recession risk has grown louder in recent weeks among investors, with the 10-year Treasury yield, touching a nine-month low of 1.80 per cent this week.

“At these levels the bond market is forecasting recession,” says Marcus Brookes, a fund manager at Schroders. “The Janet and John way to explain it is that for the next 10 years you have to think inflation will be much, much lower than 2 per cent to want to buy these bonds. Otherwise you’d be locking in a loss.”

Many investors began 2016, expecting firmer growth, led by the US and from consumer spending buoyed by cheap energy. In a few weeks, the outlook has deteriorated. Global equity and corporate bond markets have been hit, with investors heading for the exit, alarmed by China’s slowdown dragging on global trade.

At such moments, demand for government debt that pays out a fixed income accelerates but has the current rally in sovereign bond prices already run too far?

Investors face the difficult prospect of assessing whether low inflation has become ingrained thanks to the collapse in commodity prices. A greater concern: has central bank interference in financial markets made pricing so opaque that investors are risking the sort of losses incurred last April, when a European Central Bank driven rally in bond markets suddenly expired?

Negative or ultra-low yielding bonds sound unappealing, but with negative interest rates already in use by central banks in Japan, Denmark, Sweden, Switzerland and the eurozone, and major central banks indicating they are willing to do more to address low inflation, they make sense.

Mike Amey, senior portfolio manager at Pimco, one of the world’s largest investors, says 5 and 10 year bonds in the US, UK and Germany offered a relative trade against shorter maturing bonds.

“Although absolute yields are low, we think inflation and rates are likely to remain low for the intermediate or medium term, which makes bonds maturing in five to 10 years still relatively attractive,” he says.

Markets were electrified after the Bank of Japan’s surprise decision to adopt negative interest rates at the end of January. Investors now see that no tool is off the table in Japan’s desire to achieve 2 per cent inflation.

Although the negative yields introduced will affect only a small portion of bank reserves, prices for government debt around the world jumped, sending trillions of dollars of bonds into negative territory. Investors bet that other central banks would also signal easier policy, a view that has been affirmed over the past week.

In Europe, ECB president Mario Draghi announced on Thursday that global weak inflation was no impediment to the ECB adding stimulus if needed while Bank of England governor Mark Carney cited the global economy as the cause of a lower inflation forecast for the UK.

Bill Dudley, president of the Reserve Bank of New York, also damped investor expectations of an upcoming rate rise in the US by addressing tighter global financial conditions this week.

The slump in US Treasury yields has yet again embarrassed investment banking analysts who were forecasting that US borrowing costs would rise.

In early December, only two of 73 analysts polled by Bloomberg predicted the 10-year Treasury yield would fall below 2 per cent again.

“Everyone thought that (falling yields) was over, but then the Bank of Japan comes and introduces negative interest rates,” says Michael Materasso, a senior fund manager at Franklin Templeton. “Even if it’s a knee-jerk reaction, negative rates in Japan means that Treasurys look like an even more attractive investment.”

Online brokerage firms, securities houses and operators of FX trading platforms in Tokyo say Japanese investors are likely to return to the market as buyers of US Treasuries once volatility eases.

“Domestic investors have little choice but to extend beyond the 10-year JGB segment,” says Andre de Silva, head of emerging market rates strategy at HSBC.

The lifespan of the rally in government bonds will depend on how long investors keep faith in central banks, says Tad Rivelle, chief investment officer for fixed income at TCW, a Los-Angeles based asset manager. Every economic cycle has a grand narrative that eventually unravels, he says. In the late 1990s it was the information revolution, in the 2000s it was housing prices.

“This cycle the narrative has been that central banks have got the ball, know what they’re doing and can keep the game going as long as they want,” he says. “But humans have not found a way to abolish cycles.”
Additional reporting by David Oakley

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