The Bull Market You Haven’t Seen
The way Douglas Peebles talks about the $100 trillion global bond market, you’d never guess that bond investors have been on a winning streak. “The market in most countries is completely dysfunctional,” says Peebles, chief investment officer of fixed income at AllianceBernstein.
If Peebles sounds anxious, it’s because this market has brought him and his peers into uncharted territory. As markets digested the news that Britain had voted to leave the European Union, the yield on Treasury bonds maturing in 10 years touched 1.32 percent on July 6, the lowest rate on record going back to 1792, before climbing back up to a still-low 1.5 percent. Confusingly for the uninitiated, falling yields mean that bonds are fetching higher prices on the market. So the “Record Low Rates” headlines obscure what’s been a strong bull run: The 10-year Treasury has jumped almost 7 percent in price so far this year—not bad for a traditionally conservative investment—and the 30-year bond surged 17 percent. In total, U.S. government debt has delivered a $660 billion windfall to investors in 2016.
Yields outside the U.S. have sunk even lower. There’s about $10 trillion of negative-yield debt, including the 10-year notes of Germany, Japan, and Switzerland. That means investors want those bonds so much that they’ll pay for the privilege of owning them.
Why would anyone put money into a bond with a negative interest rate? For some investors, it’s worth the price for stashing money in a safe place. And traders can profit if yields sink further into negative territory, boosting the value of the bonds they buy now. Yet even many bond market professionals are baffled by negative rates. “There’s something of a mass psychosis going on related to the so-called starvation for yield,” said Jeffrey Gundlach, whose firm, DoubleLine Capital, manages $102 billion, during a webcast on July 12. “Call me old-fashioned, but I don’t like investments where if you’re right you don’t make any money.”
Low yields are sending a very gloomy message about the future. Today’s high prices and paltry yield income imply low returns in the years ahead. And the investors who accept such rates seem to be saying they aren’t concerned about the risk of high inflation eroding the value of their money; instead, they see stingy raises for workers, weak consumer spending, and slow economic growth continuing indefinitely.
“There’s just an uncomfortable feeling that we’re in a low-growth world and it may continue to get worse,” says Bill Irving, who manages $40 billion of government and mortgage bonds at Fidelity Investments. “That’s why there’s demand for bonds.”
Money usually flies toward Treasuries during uncertain times, because they’re among the safest financial assets in the world when held to maturity. And there’s uncertainty in spades: Along with Brexit and the EU’s murky future, there’s the economic slowdown in China, weak oil prices, and teetering banks in Italy. Even so, the U.S. economy has been growing, and the unemployment rate is down to levels not seen since 2007. The Dow Jones industrial average just hit a record high. There are other forces at play in the U.S. bond market besides pessimism.
One is U.S. pension managers looking to fund their long-term liabilities with less-risky assets. Foreign buyers are snapping up Treasuries, too, as central banks in Europe and Japan continue to hold down rates by buying up their own countries’ bonds. “You can no longer look at America in isolation,” says Jae Yoon, chief investment officer at New York Life Investment Management. “You have to see how much more attractive the U.S. 30-year bond is vs. Japanese and European bonds.”
Investors generally demand higher rates for locking up their money for longer times. And the prices of longer-term bonds can rise and fall sharply in response to changes in prevailing interest rates. That’s why the longest-dated U.S. Treasuries have done especially well this year. A fund investor could have earned 16.7 percent holding the Vanguard Long-Term Treasury Fund, compared with about 6.5 percent for the S&P 500.
Not that such returns were easy to foresee. Many hedge fund managers, considered the savvy players on Wall Street, failed to bet big on Treasuries, reasoning that rates were more likely to rise than to keep dropping from such depressed levels. Wall Street analysts have found themselves unable to keep up. Stephen Stanley, the chief economist at Amherst Pierpont Securities, has cut his forecast for the 10-year Treasury bond five times this year. “I’ve pretty much pulled out what’s left of my hair trying to figure out bond yields this year,” he says.
Bill Gross, the widely followed manager of the Janus Global Unconstrained Bond Fund, calls the current low-interest-rate environment pure science fiction. “It resembles a financial black hole from which no interest or yield can escape and no further capital gains are possible,” he says.
Fidelity’s Irving disagrees. He says yields could still go lower—as far as 1 percent on the 10-year—in part because high rates would cause so much economic pain that the Federal Reserve and other central bankers will keep working to keep them low. “The overall debt in the developed world is at very high levels,” he says. “Yields need to stay low to refinance that debt. Otherwise there will be defaults and losses that would be very deflationary.”
Few think the Federal Reserve will hit the bond market with sharp increases to the benchmark short-term interest rate. “The Fed is extremely risk-averse right now,” says Dean Maki, chief economist at Point72 Asset Management. He predicts it won’t act until it sees the combination of economic and job growth in the U.S., more stability in Europe, and financial markets doing well. “It’s hard to imagine them all looking good at the same time,” he says. The rip-roaring, nail-biting bond market has a hard time imagining it, too.
—With Eliza Ronalds-Hannon
The bottom line: Surging demand for bonds brought Treasury yields to a record low, signaling continued anxiety about growth.