Some time ago, Steven Major, who is the Global Head of Fixed Income for the international bank, HSBC, predicted falling yields when everyone else was predicting they would rise.
A few months on, and amidst the furor of the Brexit vote, he has been proven right as the yields on both 10 and 30-year United States Treasuries sunk to record lows.
This article lays it out in detail for you.
Britain’s vote strangles the yields’ throat
Forecasts were defied by the markets yesterday as it was announced that treasuries saw unprecedentedly low yield levels, showing that Britain’s severing from the European Union could stifle global economic growth as many predicted, which has led some to prophesize that the Federal Reserve will refuse to raise interest rates again amidst the uncertainty that has descended.
America just turned 240.
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Her birthday present was significant.
Yields on 30-year bonds dropped a whopping ten basis points to just 2.1873%.
The benchmark 10-year bond yield simultaneously fell to 1.3784%, as shown in the graph below.
Some of the biggest investors in bonds, including BlackRock, Guggenheim, and Vanguard, amongst others, have told the media that Brexit and its ensuing instability due to uncertainty mean strangled growth and lower yields in the near-term.
The US Treasuries represents the largest bond market in the world.
At a staggering $13.4 trillion, it is worth almost as much as China and Japan combined ($14.2 trillion).
The decline in yields is going to have ripples for the wider market that will spread their reverberations into the pores of countless other markets.
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Whether it is US mortgages or corporate bonds, or borrowing and lending costs for both cities and governments, everyone will feel this change.
The bull of the market for US debt began 30 years ago in the early 1980s when yields for both 30-year and 10-year peaked above 15 %.
How things have changed.
Central banks throughout the world are trying out negative interest rates in order to spur growth, which has alluded many developed economies in the last decade or so (notably Japan), an experiment which has pushed a dozen trillion dollars’ worth of government bonds, including from Japan, Switzerland and Germany, to have yields below zero and thus boost the allure of Treasuries that are still positive.
Mohammed El-Erian of Allianz, who is also a Bloomberg columnist, lays it out for us:
- In the face of negative interest rates on a third of world government debt, investors will seek positive rates wherever they can, and right now the main target is the U.S
- With a slowdown in growth, especially in Europe, China, and Japan (the sick man of the world, with no growth for 30 years) and ‘central bank activism’ as El-Erian calls it, US debt bond yields could easily see 1.25%, no problem
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The yields of benchmark Treasury 10-year notes dropped a full three basis points (0.03%) to 1.44% at 2 pm (Eastern Time, UTC-5).
Prior to this, they had fallen even lower to 1.379 percent, on July 25, 2012.
This was recorded in Bloomberg Data that went all the way back to 1962.
Conversely, the 1.625 % security that is due in ten years from May this year, grew to 101 21/32.
The yields of the US’s 30-year notes fell to 2.23%, which was less than one basis point away from the lowest closing level ever recorded.
Trading in Treasuries closed at 2 pm on Friday in New York, and per tradition, will stay closed until the 4th of July, the United States’ celebrated Independence Day. Credit to the Securities Industry & Finance Markets Association for these figures.
Forecasts for high Treasury yields have consistently been wrong across the vast majority of sources, ever since the recession ended in the United States in 2009.
Economic growth continues to remain below the 30-year average, despite the constant forecasts of it picking up.
Several metrics regarding inflation haven’t reached their targets aimed for by the Fed during its virtually unprecedented but widely expected, monetary stimulus.
Yields keeping dropping amid demand for assets that are seen as havens, such as sovereign debt.
Growing demand for bonds, record lows all round
- Swiss bond yields were all under zero, while even non-benchmark UK gilts turned negative too
- Spanish bond yields also saw record lows, while securities in the 10-year category had their best week for four years
- 10-year bonds in Germany gained for the sixth consecutive week: sub-zero yields still managed to attract investors to the debt, partly thanks to Germany’s strong economic performance compared to the Eurozone
- Japan (remember, no growth in 30 years) saw its 10-year yields post record lows, below zero, while Taiwan mirrored this with its all-time lows
- Bloomberg’s Global Developed Sovereign Bond Index recorded an all-time low of 0.45 percent
Treasuries returned 5.3% in the six months from January to June, consistent with Bloomberg index data, the best two quarters since all the way back in 2011.
Seamus McGorain, a portfolio manager for JPMorgan, tells us that US Treasuries are still high compared to anyone else in the world, meaning more rallying.
His firm oversees around $1.7 trillion worth of assets.
10-year yields could fall to 1.25% in the next few months, according to him
Treasury yields are unlikely to see a reversal.
It is an event of cataclysmic proportions that has actually increased the likelihood of a cut in interest rates instead.
Term Premium explained
In a climate of such low yields, bond purchasers are scrutinizing everything and leaving little room for error.
The term premium is a metric currently used by the Fed as a tool for guiding monetary policy: it reflects the additional compensation investors are demanding to hold long-maturity debt rather than short-term securities.
It current stands at negative 0.66 percentage points for 10-year notes.
This is one of the only times that the term premium has not been positive in the last 50 years.
It started to turn negative at the beginning of the year, and it tells us that investors fail to see any risks coming up that would increase yields.
This is as true of Japan as it is of Germany as it is of the UK, who have seen their term premium go negative: all three countries have benchmark yields at their lowest ever.
Major (mentioned in the introduction) says that what will change the term premium from now on will be a big event like central bank activity or a huge purchase of debt from someone.
A lot of the current shifts have been knee-jerk reactions to Brexit, and not much more.
People are using it simply as an excuse to further downgrade expectations and manage risk, in a climate of fragility and low confidence.
Gemma Wright, who manages portfolios and trading for more than 60 billion dollars’ worth of US debt for Vanguard, says that the near future will see a continuation of reaching for yield and like Major doesn’t see anything changing it.
Extending along the curve is to be expected in an environment of stagnant growth and low inflation.
The chance of the Federal Reserve raising interest rates again this year has slid to a measly 14%, when it was touted as 50/50 for the year according to June 23 predictions, before the unexpected results of the Brexit referendum came through.
Many saw a Remain vote as a sure thing, largely thanks to the expected status quo swing.
Warnings and Final Word
Guggenheim Partners gave us a breakdown of the details: their CIO (Chief Investment Officer), Scott Minerd, predicts yields on benchmarks tumbling to a mere one percent by the turn of 2017/2018.
Another to echo this prediction of Colin Robertson of Northern Trust Asset Management, who oversees $350 billion as the head of fixed income: he predicts a drop in 30-year bond yields to 1.65%.
Other predictions include 10-year notes trading between 1.25% and 1.65% (Wright again, let’s see if she’s right again), and an agreement with this range estimate by the Rick Rieder, who is the chief of investment for BlackRock.
Major correctly predicted record lows for Treasury yields this year, but is adamant that they won’t go any lower and warned that investors should be very careful in chasing this outcome.
A President of the Fed, James Bullard, said that low global rates simply cannot be the case forever and that when there is a rise, which there will be, investors should prepare themselves accordingly.
Bullard said that low bond yields would continue for some time, but a day will come when productivity will pick up in the US, thanks to innovation and substantial R&D investment, which will allow growth to pick up, and interest rates will go back up in line with this.
Brexit has certainly shaken up the world economy, and no doubt Major factored this into his predictions last year, something many failed to do expecting the Brits to favor stability over independence.