IN THEORY, bond markets are straightforward. Governments or corporates wishing to borrow money issue IOU notes to investors promising they will repay them at a future date while in the meantime providing them with a fixed level of interest. The longer the period until repayment, the greater the level of interest an investor might expect.
Today’s dystopian bond markets test the notion that a return should be made. The latest evidence of this was the German government successfully issuing its first-ever 30-year bond offering zero interest. The offer raised €824 million from investors willing to lend money for free. To most of us this might seem utterly crazy, but this takes place in the context of a world where over $15 trillion of government bonds traded around the globe currently do so with negative yields, guaranteeing losses if held until maturity.
The transformation of bonds from their traditional role as risk-free assets into return-free ones, is a result of a decade of ultra-low interest rates seen across the globe and the alchemist-like role that central banks have played in driving down borrowing costs by hoovering up vast amounts of bonds. The Bank of Japan, for example, now owns around half of the entire Japanese government bond market.
In recent weeks, bond yields across the globe have collapsed even further as fears about trade, a slowdown in China, and Germany teetering on the edge of recession have gathered pace. The markets have betted heavily on renewed rounds of rate cutting and President Trump has duly weighed in, banging the drum for a 1% cut in the US. Investors have swarmed into perceived safe-haven bonds, pushing up prices to extreme levels and in turn driving down yields. If you want a return that can keep pace with inflation the bond markets are an empty wasteland, with the average bond currently yielding a historically low 1.46%.
One aspect of this that caused alarm a week ago, was the yields of 10-year bonds in both the US and the UK briefly dipping lower than those on their respective two-year equivalents. This phenomenon, known as an inversion of the yield curve, defies the normal logic that the longer an investor is prepared to lend money, the higher the level of return they might expect. The last time this happened was ahead of the global financial crisis. All nine recessions since the mid-1950s have been preceded by an inversion in the yield curve, so this measure has earned a reputation as a very reliable indicator of trouble ahead. What it suggests is that lenders concerned about the economic outlook require more reward for the shorter term, than they do for the longer term.
While these inversions are a worrying warning shot, they were brief, and perhaps unsurprising in the context of global trade tensions, the potential disruptive effect of Brexit and the ongoing crisis between Italy and the EU. An inversion that persists for several weeks would be of concern as banks and other lenders consider such factors in determining their lending criteria and this could make a recession a self-fulfilling prophecy if it choked off credit.
This isn’t the scenario we are currently in. Recessions are typically triggered by rising monetary tightening, but the current direction of travel is quite the opposite.
Importantly, although all the last nine recessions were preceded by inversions, not every inversion has been followed by a recession. Where this has been the case, the time scales before the recessions have arrived have varied greatly, with the longest period coming in at four years.
While the jury remains out on when the next recession will come, investors need to tread with care in respect of parts of the market where valuations and yields have become extremely distorted, such as in the world of the bond. What the decimation of bond yields does provide is an opportunity for governments to ramp up long-term borrowings and invest heavily in infrastructure. The demise of bond yields could herald the death of austerity.
Jason Hollands is managing director at Tilney Investment Management.
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