It has been a Q1 of firsts for the global economy owing to the continuing fallout of the coronavirus crisis. Amidst record drops in crude oil and equity markets and record highs in volatility, we have also recently witnessed US Treasury yields turning negative. At the end of March, US 1-month and 3-month bond yields went briefly negative before rebounding. The only other time this has occurred was for several days in the latter half of 2015. The move came after the Federal Reserve cut its benchmark rate to near zero earlier in the month.
This dip into negative territory follows an already well-established trend in Europe where high-quality bonds across the maturity spectrum have been offering yields at or below zero. In Germany, for instance, all bonds except for the 30-year bonds are currently offering negative returns. Despite this, demand continues to grow as the flight to these safer assets continues, driving their prices up and forcing yields down. But could this flight to quality be inflating a bond bubble, as more and more investors find themselves locked into the prospect of future losses?
How we got here
All the way back at the end of 2017, evidence was building that the US economy was slowing. The yield curve flattened, providing an early indication that it was nearing the end of the business cycle and could be heading towards a slowdown. This ultimately didn’t come to pass when tax cuts were implemented leading to an increase in economic activity. The Fed raised rates three times that year and continued tightening even further in 2018, going from an announced three rate hikes to four.
In the summer of 2018, the spread between the interest rates of 3-month and 10-year treasuries narrowed and then briefly inverted. Many analysts began raising the alarm, some calling the December rate hike one too far and warning that further rate increases could lead the US economy into recession. Following market pressures, Chair Powell reduced his planned rate increases for 2019 from three to two, but the market was underwhelmed. The infamous Powell pivot ensued, in which he was forced to not only pause his hawkish agenda but to actually cut rates three times from July to October of 2019 in order to maintain asset prices. August of 2019 was also the month that the widely followed and highly accurate recession indicator, the 2-year/10-year yield curve, inverted.
As you can see, the global economy was already slowing well before the coronavirus crisis reared its ugly head. The US is a perfect case in point here as it was performing better than other countries and had maintained the highest interest rates in the developed world. But the writing was already on the wall, regardless of its trade spat with China and the increase in tensions with Iran. Market forces were steadily pressuring the Federal Reserve to cut rates further in order to bring them in line with the rest of the world and the bond market began to price these pressures in. The coronavirus crisis can be regarded as an unforeseen event that ultimately forced the Fed’s hand and hastened the inevitable.
Why run to bonds?
The question on the minds of many will be: why own bonds when yields are low, falling or even negative? There are a number of reasons for this. Take Europe as an example; with bank interest rates also in the negative, holding negative-yielding bonds can be preferable to the cost of parking your capital in a bank account. This is due to the negative yield of the bond being less of a loss than the cost incurred at the bank. In such an uncertain climate some investors will opt for the lesser of two evils as long as they get the guarantee of having most of their capital returned to them at the end of the term.
As far as the US is concerned, even after the Fed’s three cuts in 2019, US interest rates were still higher than the rest of the developed world. For many investors, there was only one likely direction for them to go in and the prospect of lower-for-longer made locking in current rates an irresistible trade. Even now, after the Fed has dropped to zero-bound interest rates in response to the coronavirus crisis, the question remains whether, like Europe and Japan, it will eventually be forced to follow suit and also go negative. This is a scenario that seemed absolutely impossible just a few short months ago.
As you can see, it’s not always about yield. In a highly risky, over-leveraged environment of slowing growth, owning bonds can also be a play on their expected price appreciation. This is what we have witnessed in the run-up to the coronavirus crisis. Investors have been willing to pay a premium for bonds, expecting that as money exits riskier assets and floods into fixed income, the price of these bonds will rise regardless of the yield they offer. For those investors who foresaw a coming recession before the coronavirus threat was even on the horizon, it has been the trade of a lifetime. Even after coronavirus put an end to business as usual, holding bonds, even negative-yielding ones, can be an attractive prospect. Particularly if you expect central banks around the world to ramp up their asset purchases and considering that many funds are still forced into purchasing bonds due to their liquidity and quality as collateral.
But is it a bubble?
You have to imagine that the largest gains in this bond market play have already been booked by investors who managed to get in early. Despite this, the continuous and unabated buying by all manner of market participants, from the pension funds to the central banks themselves, has had the effect of driving prices even higher. It bears many of the hallmarks of a bubble in an asset class that’s supposed to be characterised by safety and stability.
A counterargument to the bubble claim could be that asset bubbles are generally driven by greed. They occur due to the promise that however improbably high the price currently is, this time is different and that there are good reasons for it to continue rising higher. This is the delusion of the euphoric stage of every bubble’s inflation. However, in the case of this potential bond market bubble, especially since coronavirus, it has largely been driven by fear. This fear was originally related to the dislocation of equity prices from the conditions in the real economy and has recently morphed into a complete flight from risky assets, as the world grapples with the twin supply and demand shock that the shuttering of the world’s economies is leading to. The argument against this being a bubble states that greed quickly turns into fear at the height of a bubble but that the reverse doesn’t hold; fear doesn’t transform into greed anywhere near as easily.
However, what if the reports of the death of the world’s economy have been greatly exaggerated? What if emerging markets, many in the southern hemisphere, aren’t affected by this pandemic at anywhere the same rate as the developed economies of the north (many of the hot spots seem to be located at suspiciously similar latitudes)? Could we be looking at a scenario where the bottom suddenly drops out of “safer” bonds in favour of riskier emerging market bonds with far higher yields? Has the flight into ever-pricier low and negative-yielding bonds caused investors to lock themselves into losing trades that they will have no option but to dump en masse when the situation on the ground improves? We’ll have to wait and see, however, you’ll agree that it’s a tantalising prospect and as investors, it is our duty to look in the opposite direction of the crowd.
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