The fastest-growing asset class so far this year? Negative-yielding bonds that, if held to maturity, are guaranteed to impose a loss on investors. The stock of such bonds has almost doubled since the start of the year to about $16tn, or one-third of the global bond market.
A lot of commentators have dismissed the dramatic fall in bond yields and rise in negative-yielding debt as evidence of a bond bubble. But this is not a reflection of investors’ irrational exuberance. It is a call for politicians to act now to prevent a deflationary global economic downturn.
The best explanation for the dramatic decline in high-grade government and corporate bond yields worldwide, along with the surge in negative-yielding debt, is that investors are rationally responding to the rising risk of a deflationary global recession. Business confidence and investment are being eroded by the uncertain ebb and flow of the US-China trade war, the threat of US tariffs on autos and Brexit, along with the slowing Chinese economy that has been the bedrock of growth for many global (and especially European) manufacturers.
The fall in bond yields around the world is fuelled by investors’ desire to hedge growth-sensitive risk assets against the backdrop of rising uncertainty. This is a reflection of fears that the world could soon fall into recession, rather than evidence of an indiscriminate grab for yield, engineered by central banks.
The dovish pivot from the US Federal Reserve at the start of the year, along with subsequent policy easing by the European Central Bank, has lowered actual and expected short-term interest rates. Long-term real inflation-adjusted rates have also fallen as investors revise down their expectations for global growth, in response to a populist backlash to globalisation and liberalisation.
What is also different this time is that at this stage of the economic cycle the Fed is the only major central bank with room to meaningfully cut interest rates, albeit to a smaller degree than in previous downturns.
Policy rates in Europe and Japan are effectively at their lower bound; any moves below would constrain the supply of credit and would encourage saving rather than investment, as well as posing risks to financial stability. One obvious consequence of negative policy rates is the challenge it represents to the business model of financial institutions. Investors, meanwhile, are forced to take on more risk in duration — or the amount of time it takes for a bond’s coupon payments to recompense an investor for the initial purchase price. That renders the supposedly “safe” assets in their portfolio vulnerable to even a modest rise in bond yields.
Investors are rightly sceptical that marginal cuts in interest rates and more quantitative easing, pulling bond yields even lower, will meaningfully raise inflation expectations and boost spending, given the general growth outlook. What is needed is reduced uncertainty around trade policy, including the lifting of the threat of US auto tariffs, and growth-friendly fiscal policies, to lift business confidence and boost demand.
Mario Draghi, the ECB president, recently said that if there were a worsening in the eurozone economy, “significant fiscal policy becomes of the essence”. He is right. The eurozone’s bond market is shouting that fiscal policy is too restrictive, and by way of encouragement is offering to pay the German government and others to borrow and spend.
A debate on fiscal stimulus by the eurozone’s largest economy is under way in Berlin, but it lacks the urgency that investors are calling for, and which the deteriorating German and eurozone growth outlook warrants. The Japanese government, for its part, should again defer its planned increase in sales tax in October.
Government bonds remain an important diversifier of the growth risk in investor portfolios, despite these low and often negative yields. But investors must also be wary of painful market losses from even a partial normalisation of interest rates, against the backdrop of lengthening bond maturities.
For bond investors seeking income, there has been little choice but to try to make money by exploiting shifts in pricing and volatility along the curve, while taking idiosyncratic risks in sovereign and corporate credit.
Asset bubbles are characterised by cheap money fuelling a credit-financed rise in asset prices to levels not matched by fundamentals. Each time, the prospect of further price appreciation is justified by increasingly outlandish claims of “this time it is different”.
But this year’s dramatic fall in bond yields and surge in negative yielding debt are a call for fiscal policy to support growth. Monetary policy is not yet wholly impotent but politicians need to heed the markets’ plea to reduce trade tensions and pursue growth-friendly fiscal policies. Sooner or later governments, rather than central banks, will have to take the lead.
David Riley is chief investment strategist at BlueBay Asset Management in London
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