Checking in on the Bond Markets

Government bond markets across the globe have continued to rally in recent weeks, with yields falling sharply even as stock markets remain reasonably buoyant. It appears that the predictions calling for the end of the great bull market in bonds may have been a bit premature. Of course, it’s anyone’s guess as to whether the insatiable appetite for government bonds will continue. But the continued strength in government bonds, especially those considered “safe havens,” does seem a bit ominous considering the hopeful economic indicators we had been getting as recently as April (particularly in the US). Has the global economic outlook deteriorated that much in just one month?
The first chart below shows that demand for government bonds in “safe-haven” countries has surged over the past few months. These “safe-haven” countries, which include the US, Germany and Japan, generally enjoy positive investment inflows during times of global economic uncertainty. And because bond prices move in the opposite direction as yields, these countries have all seen a precipitous drop in yields on their government debt. In the US, the yield on the 10-year Treasury bond has dropped 1.00% from a high of about 3.23% in late 2018 to the current 2.23%. This abrupt reversal has left a great many economists scratching their heads. Why are interest rates falling even as economic growth accelerated in 2018 and the first quarter of 2019? Is it possible that the one-two punch of tax cuts and increased government spending has so quickly lost its potency?
But perhaps even more surprising is the fact that yields on the 10-year German and the 10-year Japanese bonds have sunk back into negative territory for the first time since 2016. A negative bond yield means that you have to pay the German or Japanese government for the honor of lending them money for 10 years. Are investors so fearful of losing money on alternative investments that they’re willing to incur a guaranteed loss? Or do investors think yields are headed further into negative territory as a result of deflation or a global recession, for example. Neither proposition seems like a very healthy sign to me.
If we take a closer look at the US Treasury market in isolation, the signals don’t get much more encouraging. Investors track the difference in yields between short- and long-duration bonds because these “yield spreads” have historically provided a reliable indicator about the future direction of the economy. The rationale is that if yields on long-duration bonds are lower than yields on short-duration bonds, it could be a sign that: 1) inflation is expected to decrease materially; 2) the demand for credit is expected to fall; or 3) risk(ier) assets are expected to incur sizable losses. Each of these potential scenarios is usually associated with slower economic growth or even recession.

Perhaps the most widely followed spreads are the 3-month Treasury to the 10-year Treasury and the 2-year Treasury to the 10-year Treasury. As you can see from the chart below, the yield spread between the 3-month and 10-year Treasuries went negative in March (where it remains) for the first time since the Financial Crisis. However the 2-year to 10-year spread remains positive, albeit by only about 0.15% and trending in the wrong direction. You’ll hear various pundits offer up explanations as to why the yield curve is flattening and has even become inverted in some spots. These “this-time-it’s-different” explanations may be perfectly valid, but one thing is almost certainly true: an inverted yield curve is not a sign of a robust and strengthening economy. A strengthening economy would usually be associated with rising (or at least stable) inflation, higher demand for credit, and an increased willingness to invest in risky assets (rather than “risk-free” government bonds).

Another yield spread that investors track is the spread between the 10-year Treasury yield and the S&P 500 dividend yield. The table below show that during periods in which investors are able to earn a higher yield by buying the S&P 500 than by buying a 10-year Treasury bond, it is usually a good time to buy stocks (and sell bonds). Conversely, when the difference between the 10-year Treasury yield and the S&P 500 dividend yield is relatively large, it’s usually a good time to reduce exposure to stocks (and buy bonds). Currently, a Treasury bond still pays out about 23 basis points more than the S&P 500 (2.23% vs. 2.0%), but that spread is trending lower due largely to a precipitous drop in long-term interest rates. Since the end of the Financial Crisis in June, 2009, we’ve seen the spread go negative twice for sustained periods, with each of those periods coinciding with a deceleration in economic growth. Will it happen again?
In such periods when the bond markets are telling a vastly different story than the equity markets, it helps to ask why. There will always be people on CNBC telling you why “this time it’s different,” but it is nonetheless entirely valid to question why the appetite for bonds with such low yields remains incredibly strong. At the very least, the bond markets are telling us that governments’ and central banks’ efforts to jumpstart global economic growth and avoid deflation through aggressive fiscal and monetary policy are probably not done. At worst, the bond markets could be foretelling the onset of the next global economic downturn. Neither scenario is especially promising. But then again, almost 10 years of heavy fiscal and monetary support, leading to subdued but consistent growth, has been very profitable for stock investors who have remained invested. In the estimation of many market pundits, the stock market continues to hold up well because of the prospects of future Fed interest-rate cuts and more of the same “muddle-through” environment that has generated excellent equity returns over the past 10 years. Perhaps they’ll prove correct. Long-term Treasury bonds, on the other hand, are rapidly losing their investment appeal as yields continue to drop.