Why US bond yields could be going the way of Germany and Japan
Ten-year US Treasury yields could be headed to zero. This is not a forecast. This is not a bold prediction. This is not something that we hope happens.
This is an observation of what is unfolding in the markets right in front of us. The 10-year yield peaked at 3.25 per cent in November last year and has fallen relentlessly, to as low as 1.93 per cent earlier this month. Today, about one-third of the global government bond market and one quarter of the global aggregate bond market have negative yields. We should consider it a warning: that this is the path the US market is on unless there is an adequate policy response.
What is surprising is that the dramatic decline in yields has happened against a backdrop which would have suggested otherwise. The last move by the Federal Reserve was to raise interest rates in December. The central bank is also in the process of running down its balance sheet by up to $35bn per month. Assets in US money market funds have increased steadily over the last nine months to about $3.3tn, the highest level since the financial crisis, when the Fed provided an unlimited guarantee to these funds. Equities, gold and cryptocurrencies have all risen strongly. Further, the US economy could be characterized as “OK”.
So, what is driving the flows into US government bonds, and where is the money coming from? More importantly, if all of these factors turn, where do yields go from current levels?
Quite simply, the money is pouring into the US bond market from overseas. As the volume of negative-yielding debt grows across Europe and Japan, investors are seeking a safe haven that has a positive return. US investors have neither embraced the decline nor pushed back against it. As trade tensions escalate, the probability of recession rises. There is also the very real risk that inflation expectations have become unanchored and central banks are gradually becoming powerless. New York Fed president John Williams captured this risk nicely this month by saying that “investors are increasingly viewing these low inflation readings not as an aberration, but rather a new normal”.
While there has already been a dramatic decline in US yields, an accelerated move lower is potentially in the offing. If, as expected, the Fed begins a rate-cutting cycle at the end of this month, money will be shaken out of money-market funds into bond funds in an effort to lock up a higher yield. A second vast pool would come from a return to balance sheet expansion: the Fed is expected to end its balance sheet run-off in September just as the European Central Bank returns to quantitative easing. A third pool of money could come from de-risking. An escalation in the trade war has surely raised the probability of recession. From current levels, the combination of central bank action and de-risking would accelerate the journey of US bond yields toward zero. This is not healthy for savers who rely on a fixed income or for insurance companies and pension funds that have returns targets to meet.
There needs to be a policy response that is swift and dramatic enough to stop this descent in its tracks, while reigniting growth and inflation expectations. A starting point is with the central banks and the Fed in particular. It must respond at month-end with “shock and awe” to regain control. A mere 25 basis-point cut by the Fed will probably be dismissed by the markets, and investors will pile into intermediate and long duration bonds. Whether policymakers cut by 25bp or 50bp, they must make it clear that they mean business and will do whatever it takes from that point onward to raise inflation expectations.
For their part, the ECB and outgoing president Mario Draghi got the ball rolling on Thursday by indicating that a significant degree of monetary stimulus is both needed and forthcoming.
While multiple significant central bank policy responses are likely to happen, it is important to remember that monetary accommodation alone is not enough to avoid recession this late in an economic expansion. Otherwise, we would never have recessions. Will it buy enough time for a policy response to happen elsewhere? While there could be a de-escalation in trade tariffs, the direction of travel over the past 18 months has not been encouraging. It would also be nice to see some co-ordinated fiscal stimulus. But which government has the courage and ability to embark on a big spending programme?
The central banks must take the lead, and they must start this month. They must bring front-end real yields so low and so fast, that the yield curve steepens. That will cause investors to question the wisdom of holding longer maturity bonds in the face of central banks committed, on a co-ordinated basis, to reflation.
Anything short of that risks the 10-year US Treasury remaining on the well-worn path, forged by Japan and Germany, toward zero.
Bob Michele is global head of fixed-income at JPMorgan Asset Management