As the first quarter ends, equities are sitting on solid gains even as a rally in government bonds has left yields in Germany negative for the first time since 2016.
As the first quarter ends, equities are sitting on solid gains even as a rally in government bonds has left yields in Germany negative for the first time since 2016.
The decline in yields has quickened this week, allowing Germany to sell 10-year Bunds with a negative yield. In the US, the 10-year Treasury yield has fallen below that of the three-month Treasury bill, a warning that the clock is ticking on a US economic expansion that, by sheer length, almost rivals the fabled run of the 1990s.
There is a legitimate debate as to whether global economic weakness is temporary or evidence that the expansion since the financial crisis is truly waning. But the message the yield curve has started to send in recent days is hardly comforting.
This debate previously played out in 2015 and early 2016. Then, hefty fiscal stimulus from China, allied to bond-buying from the Bank of Japan and the European Central Bank, managed to end the soft patch. The election of US president Donald Trump, and the tax cuts that followed, added momentum to global growth that eventually peaked early last year.
The double-digit gains for many equity markets this year have been helped by the signals sent by central banks — still struggling to hit their inflation targets — that they are willing to ease policy, or, in the case of the Federal Reserve, sit on the sidelines. It has had the effect of loosening financial conditions, helping equities and credit.
Stock markets are fairly forgiving about weak earnings growth, or even a fall in profits, so long as there are grounds for an eventual bounce. If the global economic data improve in coming months and Washington and Beijing strike a trade deal, then financial markets could be soothed for a while.
But even in such a scenario, do not expect a dramatic reversal of the trend for falling bond yields.
It is notable that the decline in bond yields has been across developed economies, suggesting a slowing China is leaving a mark. Two of the bond markets spearheading the move lower in yields have been Canada and Australia. While the housing markets in both countries are under pressure, their role at the vanguard of the bond rally suggests that Beijing’s stimulus is a pale shadow of past efforts.
The volume of negative-yielding debt rising back above the $10tn mark also makes the Treasury market a magnet for investors seeking higher yields. There is an argument that this is distorting the bond market, and that 10-year yields are too low given the US economy’s growth prospects for 2019.
The fact that falling bond yields is a global phenomenon also eases the selling pressure on the US dollar, as we have seen in recent weeks. A firmer reserve currency tightens financial conditions too, hardly a welcome development for US companies given the exposure of S&P 500 blue-chips to the global economy. With the Fed stuck on policy pause and still trimming its balance sheet until September, at some stage — and perhaps soon — the equity market may start fretting about “tight” policy, particularly if the dollar appreciates further.
All of which is central to the debate over the significance of the 10-year yield sliding beneath the rate for a three-month bill. It certainly sends a signal to Fed officials that policy is too tight. As recently as October, the 10-year note yield stood 100 basis points above the implied three-month bill yield, which was cited by many as a good reason for not worrying about the risk of a recession. Those questioning the meaning of the first inversion since 2007 will be silenced if it becomes sustained and deeper.
The bond market is not forecasting a recession; it is simply flagging a higher risk of one. Clearly, the market turmoil of late last year showed the limits of the world’s most important central bank’s effort to tighten policy. The recent clamour for sovereign bonds is also a sign that tension is building across markets.
The rationale is not hard to fathom. A decade since the previous global recession, equities and credit are expensive, and now likely to rise further courtesy of lower bond yields. At the same time, the weight of debt that requires servicing is far heavier. Global debt has climbed by $100tn from just before the financial crisis and sits around $240tn. The bill is coming just as global growth is slowing, corporate earnings growth is stalling and profit margins are contracting.
It was popular to downplay the significance of the inverted curve in 2000 and 2006, but on both occasions, the bond market’s warning was eventually vindicated. That help explains the confidence of fixed-income investors who are looking beyond the current cycle and already anticipating the next move from the Fed will be to cut rates.
