Record-low – and negative – bond yields. Stagnant economic growth. Nosebleed levels of economic and political uncertainty. Looming deflation. Meanwhile, some stock markets – most notably, the U.S. – are hitting record highs.
As we’ve written before, if you really want to know what’s happening in the world economy you need to look at what the bond market is saying. But these aren’t normal times, and looking to the bond market for guidance is, well, misguided.
What falling bond yields usually mean
Under normal circumstances, falling government bond yields often signal trouble. (Bond yields and bond prices move inversely – when one rises, the other falls, and vice-versa.) This is partly because when more investors feel the economy is headed for trouble (and/or they think that stock markets will fall) they buy bonds. Government bonds usually weather economic storms better than most investments.
When there are a lot of bond buyers, bond prices go up – as with anything where there are more buyers than sellers. When bond prices go up, bond yields fall. So when you hear that bond yields are at new lows, it means bond prices have gone up.
Right now, government bond yields all over the world are at historic lows. As we’ve explained before, some have even gone negative. What this means is that there are a lot of investors buying bonds. But in this instance, the signal the bond market is sending isn’t at all clear.
What the yield curve is saying
As we explained before, when the yield on 10-year U.S. government bonds, or treasuries, drops below the yield on shorter-term U.S. Treasuries, it’s called an “inverted yield curve.” This almost guarantees a recession is coming.
Even though 10-year U.S. Treasury yields are the lowest they’ve ever been, the yield curve has not yet inverted. That’s because 2-year Treasury yields are also at historic lows. Short-term yields, like for 2-year treasuries, are so low it might not be possible for the yield curve to invert.
But the spread (that is, the difference) between the two is shrinking, which is not a good sign. When we wrote about the yield curve in February, we noted how the spread between the two had fallen below 1 percent for the first time since the 2008 financial crisis.
The spread has narrowed even further since then – the 10-year yield is now only 0.86 percentage points higher than the two-year yield. This is also normally not a good sign. Because of this, Deutshce Bank analysts recently said that they think there’s a 60 percent chance that the U.S. economy will fall into recession within the next year.
But bond yields may not be the reliable indicator they once were
But despite the danger that comes with saying that “this time it’s different”, there is a big difference now compared to what’s usually the case. The difference is quantitative easing (QE), which has turned the world of finance upside down.
The U.S. spent US$3.5 trillion on U.S. Treasuries, or government bonds, and other debt instruments like mortgage-backed securities during its QE programmes that ran from November 2008 to October 2014. The goal was to buy so many bonds that bond prices would climb and stay high, which would force bond yields, and borrowing costs, lower. (This, in turn, was to help spur borrowing, and thus, economic growth.) And in this respect, it worked spectacularly.
Japan and Europe joined the QE party, with the European Central Bank (ECB) currently buying 80 billion euros (US$88 billion) worth of securities each month, mostly government bonds. And they plan on doing this until at least next March, on a programme that will total over US$1 trillion.
The Bank of Japan (BOJ) has officially said it will spend US$750 billion per year on its QE programme (some say it is spending more than that). The BOJ now owns about one-third of all outstanding Japanese government debt.
Then add that to the US$3.5 trillion already spent by the U.S. Fed for its QE programmes, and the sharp decline in bond yields in recent years makes sense.
Importantly, this is all additional demand – besides the normal demand for bonds from pension funds, banks, insurance companies and asset managers.
And since many governments don’t want to take on more debt than they already have (which is also at record levels), there is a falling supply of new bonds to buy in some countries.
In fact, according to Bloomberg, the ECB may soon run out of German bonds to buy because the negative yields on a growing number of German bonds are ineligible for purchase under their QE programme. This will only force it to buy, and drive up the prices of, other eligible bonds.
What it all means
Bond yields have declined partly because trillions of dollars of QE money are being used to buy bonds at just about any price. Additionally, investors – fearful of the uncertainty of Brexit, the scope of an economic slowdown in China, and many other factors – are buying U.S. Treasuries in a “flight to safety,” despite low yields.
Falling yields could be another symptom of the “everything bubble” that central banks around the world have inflated. Everything from bond yields to stock markets to real estate are at historic levels because of low interest rates and easy money.
As concerning as the recent fall in bond yields has been, it may not be the reliable indicator it once was. In the past, falling bond yields were a good signal the economy was heading for trouble. But it’s hard to trust this indicator now, when there’s so much noise and capital chasing bonds.
But rock-bottom yields mean that things aren’t right – whether it’s a recession or something else coming soon.
Investors who think that bond yields will continue to contract – and that U.S. Treasuries will be the next to pierce the negative interest rate horizon – might consider the iShares 20+ Year Treasury Bond Fund (New York Stock Exchange; ticker: TLT), an ETF that tracks the price of 20-year U.S. Treasuries. It’s up 20 percent over the past year, and 7.4 percent over the past three months.
But betting on the continuation of a multi-decade bull market in bonds, at this late date, is a risky trade.