Bond Bubble Dismissed as Low Yields Echo Pimco’s New Normal
Mohamed El-Erian knows why bond markets from the U.S. to Germany to Brazil, where yields have dropped to record lows even though debt has ballooned to more than $40 trillion worldwide, aren’t a bubble waiting to burst.
“We may be in a synchronized slowdown” in global economic growth, El-Erian, who as chief executive officer of Pacific Investment Management Co. oversees $1.77 trillion, said in a June 6 telephone interview. “We could stay here for a while.”
The average yield on bonds issued by the Group of Seven nations has fallen to 1.120 percent from 3 percent in 2007, Bank of America Merrill Lynch index data show. Germany’s two-year note yield fell below zero for the first time on June 1, while Switzerland’s has been negative since April 24, meaning investors are paying for the right to lend the nation money.
Those rates suggest that bondholders don’t expect growth to exceed 3 percent, said John Lonski, chief economist at Moody’s Capital Markets Group in New York. The rate had represented the dividing line between growth and recession as recently as 2009, according to the International Monetary Fund, and compares with an average of 4.7 percent in the five years before the financial crisis took root in 2008.
Yields on government securities in the U.S., Germany, the U.K., Austria, the Netherlands, Finland and Australia tumbled to all-time lows this month as Europe’s debt crisis intensified, manufacturing worldwide slowed and unemployment in the U.S. unexpectedly rose. Even in emerging markets, such as Brazil and India, engines of growth in recent years, yields signal a slowdown and less inflation.
Spain became the fourth euro member to seek a bailout since the start of the region’s debt crisis more than two years ago with a request two days ago for as much as 100 billion euros ($126 billion) in loans to rescue its banking system.
“As far as developed economies are concerned, the credit market is coming to the conclusion that real economic growth will be slower than what we’ve become accustomed to since the Second World War,” Lonski said in a June 5 telephone interview.
Treasury 10-year yields closed at 1.64 percent on June 8. German bunds of similar maturity finished at 1.33 percent and Japan finished at 0.85 percent. All are below the 3 percent rise in consumer prices worldwide forecast for this year by the investment banking unit of London-based Barclays Plc.
“You’re not talking about a bubble because a bubble is about greed,” Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Inc. in New York, which has $3.68 trillion under management, said in a June 6 telephone interview. “That’s not a reflection of ‘I expect prices to go higher and I have to jump in,’ that’s a reflection of ‘I want to preserve my principal.’ Negative yields reflect fear.”
Government bonds have returned about 2.5 percent since mid- March, including reinvested interest, according to the Bank of America Merrill Lynch Global Sovereign Broad Market Plus Index. At the same time the MSCI All-Country World Index (MXWD) of stocks lost 9.3 percent with dividends, while the Standard & Poor’s GSCI Total Return Index of metals, fuels and agricultural products fell 16 percent.
After shooting to as high as 2.4 percent on March 20, yields on 10-year Treasuries fell as low as 1.44 percent on June 1, when the U.S. Labor Department said the unemployment rate rose to 8.2 percent in May from 8.1 percent in April. Today, the yield on the benchmark 1.75 percent note due May 2022 dropped two basis points to 1.61 percent at 1:08 p.m. in New York, following an 18 basis-point increase last week. The yield fell as low as 1.59 percent after trading as high as 1.73 percent.
Policy makers are taking action amid the steepest slowdown since the recession ended in 2009. Australia’s central bank cut interest rates on June 5, and two days later China made its first reduction in more than three years.
European Central Bank President Mario Draghi left the door open for a rate cut at a June 6 press conference, while highlighting the limitations of the ECB’s tools in countering the region’s financial turmoil. Federal Reserve Chairman Ben S. Bernanke told a Congressional committee last week that policy makers will discuss whether to do more to spur growth after flooding the financial system with $2.3 trillion by purchasing bonds, though he said the steps they could take may have “diminishing returns.”
The slowdown matches the prediction by El-Erian of Pimco in 2009 for a “new normal” in global economies characterized by a slower pace of expansion, higher unemployment and a greater role for governments in private markets following the worst financial crisis since the Great Depression.
Pimco officials point to Japan, which has been in and out of recession since the mid-1990s, as what the new normal would look like. Even though it has the world’s largest debt load at more than $11 trillion, Japan has some of the world’s lowest bond yields because of years of below-average growth.
Japanese 10-year yields fell to 2 percent in late 1997 from about 5.7 percent eight years earlier when the country’s stock and real estate markets collapsed. They haven’t closed at or above 2 percent since 2006. The U.S. 10-year yield tumbled below that level about four years after rising to 5.29 percent in June 2007.
Global “bond markets are turning Japanese,” Bill Gross, who manages the world’s biggest bond fund as co-chief investment officer with El-Erian at Newport Beach, California-based Pimco, said in a June 4 Twitter posting.
“In many ways, we are replicating the Japanese experience,” George Magnus, senior economic adviser in London at UBS AG, said in a June 5 telephone interview. “Banks and households have become overextended, and now we know governments have also become overextended. The problem is that the deleveraging means people are saving more. There is no sufficient spending and lending to boost the economy.”
Investors from Leon Cooperman, founder of equity hedge fund Omega Advisors Inc., to Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., have said that investors should avoid bonds. Most bears say the easy money policies of central banks combined with the rising amount of debt will eventually spark a rapid acceleration in inflation.
“The government bond bubble will burst,” Marc Faber, author of the Gloom, Boom & Doom report, told Sara Eisen on Bloomberg Television’s “Inside Track” on June 7. “I don’t know whether it’s going to be tomorrow or in three months. But I suspect that it will happen sooner rather than later because the consensus now is to buy U.S. Treasuries.”
The supply of bonds has swelled as governments borrowed to stimulate their economies. The Bank of America Merrill Lynch Global Broad Market Index tracks debt issues with a face value of $40 trillion, up from $24 trillion in June 2007 and $15 trillion a decade ago.
Central banks, including the Fed, ECB and Bank of Japan (8301), have helped soak up the extra supply as policy makers injected money into their economies by purchasing government securities. The balance sheets of the world’s six biggest central banks have more than doubled since 2006 to $13.2 trillion, according to Chicago-based Bianco Research LLC.
“A lot of people from Warren Buffett on down would say the bond market has no value, be careful of bonds, when rates go up you’ll lose a lot of money,” James Bianco, president of the firm, said in a June 7 telephone interview. “And they’re right, but the buyer of bonds doesn’t care about value right now. The buyer of bonds is the central bank of Japan, the central bank of China.”
Financial institutions are also contributing to demand, buying from a shrinking supply of the highest quality debt to meet capital requirements set by the Basel, Switzerland-based Bank for International Settlements. The Basel III rules will “increase the price of safety” embedded in assets deemed a reliable store of value, the IMF wrote in an April 18 report.
Investors have bid $3.19 for each dollar of the $903 billion of notes and bonds auctioned by the U.S. Treasury Department this year, above the record $3.04 in all of 2011, data compiled by Bloomberg show.
Yields that are negative after accounting for inflation may be a sign that investors expect the pace of consumer price gains to slow, or fall like the deflation in Japan. Copper has declined 18 percent in the past 12 months, aluminum has tumbled 23 percent, cotton plunged 47 percent and oil has dropped about 14 percent.
A measure of investor expectations for inflation used by the Fed to set policy, the five-year, five-year forward break- even rate, which gauges the average increase in prices between 2017 and 2022, dropped to 2.56 percent on June 4, from a 2012 high of 2.78 percent on March 19.
Emerging market sovereign yields fell to 5.33 percent last month, within two basis points of the record low reached in November 2010, according to the JPMorgan Emerging Bond Index Global Sovereign Yield.
Brazil will expand 2.72 percent this year, according to a central bank survey of analysts published on June 4. That would follow growth of 2.73 percent in 2011, the second-worst performance in eight years.
Two-year bond yields in Brazil fell to a record low of 8.4 percent on May 18, from about 12.6 percent a year earlier, as the central bank cut its benchmark rate seven times since August to bolster the economy. A bond market measure that reflects investors’ expectations for inflation plunged to a three-year low of 4.7 percentage points last week.
In India, where 10-year yields fell for the sixth-straight week, the longest run of declines since December, interest-rate swaps show the central bank will cut borrowing costs for a second time this year. Asia’s third-largest economy grew 5.3 percent in the first quarter from a year earlier, a nine-year low, the government said May 31.
“Yields are extremely low for a very good reason, and that’s fear,” Stuart Thomson, a money manager at Ignis Asset Management in Glasgow, which oversees about $115 billion, said in an interview on June 1. “I don’t see us heading into a bear market.”
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