Most Expensive Bond Market in History Has Come Unhinged. Or Not.by and
Global yields are lowest since at least 1871, says Jack Malvey
Term premiums in U.S., Japan, Germany and U.K. turn negative
Today’s bond market is defying just about every comparison known to man.
Never before have traders paid so much to own trillions of dollars in debt and gotten so little in return. Jack Malvey, one of the most-respected figures in the bond market, went back as far as 1871 and couldn’t find a time when global yields were even close to today’s lows. Bill Gross went even further, tweeting that they’re now the lowest in “500 years of recorded history.”
Lackluster global growth, negative interest rates and extraordinary buying from central banks have all kept government debt in demand, even as yields on more than $8 trillion of the bonds dip below zero. But as investors forgo any margin of safety to bid up prices higher and higher, the big worry is that the insatiable demand has blinded them to potential dangers that may result in painful losses -- especially as the Federal Reserve considers raising rates.
“This absolutely leaves the markets a lot more vulnerable,” said Torsten Slok, the chief international economist at Deutsche Bank AG.
Beyond the bubble of the bond market, history offers some clues. Ten-year U.S. government notes now yield less than stocks pay in dividends -- just the third time that’s happened in the past half-century. The last two times, Treasuries suffered their biggest annual losses on record.
The stakes couldn’t be higher. Average yields for 10-year notes in the U.S., Japan, Germany and the U.K., which have issued more than $25 trillion in government debt, fell to 0.69 percent last week, data compiled by Bank of New York Mellon Corp. showed. That’s the lowest on record and well below the 5 percent average over the course of 145 years.
With yields so low, bond buyers are leaving themselves no room for error. In the U.S., a metric known as the term premium now stands at minus 0.47 percentage point for 10-year notes. The measure, which the Fed uses as a tool in guiding monetary policy, reflects the extra compensation investors demand to hold longer-maturity debt instead of successive short-term securities.
As its name suggests, the term premium should normally be positive and has been for almost all of the past 50 years. But since the start of the year, the premium has turned into a discount, suggesting that bond investors can’t see any risks on the horizon that would push yields higher. The same is true in Japan, Germany and the U.K., where the term premium has gone negative as benchmark yields in all three markets hit all-time lows last week.
The “term premium should almost never be negative, but we’re in a new normal,” said Stanley Sun, a New York-based strategist at Nomura Holdings Inc., one of 23 dealers that trade directly with the Fed.
For the pessimists, there are plenty of reasons to keep paying up for the safety of government debt -- even at sky-high prices.
The odds of the U.S. entering a recession over the next year are now the highest since the current expansion began seven years ago, according to JPMorgan Chase & Co. The Organisation for Economic Cooperation and Development also warned this month the global economy is slipping into a self-fulfilling “low-growth trap.” What’s more, Britain’s vote on whether to leave the European Union this month has been a major source of market jitters.
“Markets are becoming increasingly convinced that developed nations may be less able to create inflation even if they want to,” said Neela Gollapudi, the head of portfolio management and research at Gentrust Wealth Management, which oversees $1 billion.
Last year, inflation in developed economies slowed to 0.4 percent and is forecast to reach just 1 percent in 2016 -- half the 2 percent rate most major central banks target, data compiled by Bloomberg show.
Yet some say that quantitative easing, or the aggressive bond-buying stimulus that central banks in Europe and Japan are currently pursuing, is causing many debt markets to become unmoored from their fundamental value.
That may help to explain the record demand at U.S. government debt auctions this year. With almost all the negative-yield debt concentrated in the euro area and Japan, investors are pouring into Treasuries, which offer some of the highest yields in the industrialized world. Demand at sales of two-, five- and seven-year notes last month soared to all-time highs, according to data compiled by Bloomberg. Foreigners also bought the most Treasuries at the May auctions since 2011, data compiled by TD Securities showed.
An unintended consequence of QE is that it leaves “an asset price devoid of its valuation,” said Jim Caron, a money manager at Morgan Stanley Investment Management, which oversees $406 billion.
Based on relative value to stocks, U.S. government bonds are overpriced. Yields on the 10-year note were at 1.62 percent today, set for the lowest close since 2012. That’s about a half-percentage point below the 2.17 percent dividend yield for the S&P 500. On that basis, Treasuries have been more expensive than U.S. equities for five months, which has occurred on only two other occasions -- in 2008 and 2012, data compiled by S&P Global Inc. show.
Treasuries went on to post their worst annual returns on record, losing 3.7 percent in 2009 and 3.4 percent in 2013, according to index data compiled by Bank of America Corp.
“There’s more risk in the bond market,” said Keith Wirtz, the Minneapolis-based chief executive officer at Walrus Partners.
Some of the bond market’s brightest luminaries are sounding the alarm over the potential fallout. Gross, the manager of the $1.3 billion Janus Global Unconstrained Bond Fund, said that ultra-low bond yields worldwide are a “supernova that will explode one day.”
Malvey, Bank of New York Mellon’s chief global markets strategist, is more sanguine but acknowledges “the possibility of unintended consequences certainly can not be ruled out.”
Goldman Sachs Group Inc. is telling investors they’re woefully unprepared for higher U.S. interest rates. The New York-based firm says there’s a 35 percent chance the Fed will raise rates next month -- more than double what the bond market has priced in. The disparity persists despite the fact that Fed Chair Janet Yellen said on June 6 the U.S. economy is in good shape and the central bank will raise rates gradually. The Fed’s next meeting is set for June 14-15.
Whatever the case may be, one thing is clear: there’s never been a bond market quite like this one.