August has once again delivered on its reputation for providing a profound market shock. And for once, the flightier areas of equities and currencies are not the culprits. Instead, the foundation blocks of global financial markets — safe and boring government bonds — have slumped to new record-low yields, many of them below zero.
The apparently frictionless expansion of negative yielding debt, and indeed its acceptance as part of the current financial system, compounds the asset allocation problems facing investors in the future. Above all, it heightens the worry that a major accident is around the corner.
An entrenched world of negative yields upends the important role played by government bonds in providing insurance or ballast for portfolios that generally favour equities and credit. As fixed-rate coupons shrivel, and as bond investors rely ever more on price appreciation to hit return targets, holding bonds becomes little different from holding stocks.
The bond-market milestones reached this month are truly stunning. US Treasury yields out to 30 years fell below 2 per cent for the first time as about $16tn of negative-yielding debt around the world acts as a powerful magnet towards the long end of the curve. The entire German Bund market went one step further and dropped below zero. Bond markets in Japan, Switzerland and Sweden sit in negative territory, alongside half of global investment-grade debt sold by companies (outside the US).
The distorting influence of negative yields across global fixed income has emerged in recent years as central banks have become major holders of bonds as they try to boost economic growth and inflation. But such activities have failed to offset long-term trends depressing bond yields such as ageing populations and rapid technological change, which respectively boost savings rates and dampen inflationary pressure.
What the August bond shock reveals is that a key part of the financial system expects no relief from these secular forces, well into the next decade and beyond. There has clearly been pressure among insurers and pension funds to buy long-dated bonds that can offset the cost of their future liabilities. Bond markets are also dominated by investors who typically follow a benchmark, which means that as yields drop and prices rise, so does the need to increase the pace of buying. Lagging the benchmark runs the risk of losing clients, and this creates a powerful herding trend — and one which is exacerbated by the rise of fixed-income focused exchange traded funds over the past decade.
This means that holders of bonds with low and negative yields are painfully exposed to even a modest rebound in growth and inflation expectations, which should naturally cause yields to rise. But as the global economy feels a squeeze on manufacturing and forlornly waits for signs of a genuine truce in the US-China trade war, bond prices, for now, reflect expectations of weaker growth and the hope that central banks will repeat their previous doses of extraordinary monetary policy.
That stands to reward buyers of negative-yielding debt via a further appreciation in price. And anticipating this gloomy prospect has bought some relief from a broader reckoning for markets. Diversified investment portfolios have benefited from the tailwinds of the bond rally. A global index of government bonds, for example, has returned some 8 per cent over the past 12 months, compared with a drop of 2 per cent for the FTSE All World stock index. An index of US Treasury bonds with a maturity of more than 20 years has appreciated by more than one-fifth this year alone, with price performance enhanced by the August grab for long-dated paper.
That is comforting for now. But from here, as Dhaval Joshi at BCA Research notes, the picture is not encouraging. ‘’At ultra-low bond yields, the risk of owning bonds converges with the risk of owning equities. The short-term potential for capital appreciation — nominal or real — diminishes, while the potential for vicious losses increases dramatically.’’
The financial system is thus left exposed to any abrupt rise in bond yields while having little scope for strong price appreciation, given the extreme moves that already reflect plenty of bleak growth and inflation data down the road. What should really worry people is how a prolonged episode of negative and lower-yielding government bonds intensifies the challenges facing bank profitability. There are also red flags fluttering over valuations for pension funds and the viability of insurers, as bond coupons shrink.
Herein resides ammunition for the next episode of financial market distress, which played a major role in torpedoing the global economy in 2001 and 2008. That is the worrying long-term message of this August market shock.
Get alerts on US Treasury bonds when a new story is published