Turning Japanese

The Australian fixed income market has enjoyed strong gains over the last twelve months with the benchmark 10year government bond rallying 11.50% YTD and 19.85% over the last 12 months, outperforming the stock market by 3.35% in the same period. Its nominal yield is 0.98% or adjusted for inflation (CPI = 1.6%), -0.62%.

Last week the 30-year German government bond yield dropped below zero for the first time ever. At every point of the German government yield curve is currently trading with negative yields. Nearly all the Japanese government bond curve is also below zero percent, with the 30-year trading at a near zero yield of 0.28%.

Source: Bloomberg

With the current global race to zero (or below) phenomenon that is taking place, it is also no longer absurd to think that US Treasury yields can go negative. There's already $14 trillion USD equivalent of bonds around the world trading at negative yields, or 25% of the entire bond market according to Bloomberg data. US Treasuries, the world's favourite safe-haven other than gold, will see negative yields, with or without a recession being required.

Drivers of negative yields

Central banks are the villains of low or negative interest rates, but they are often forced into action by market forces. Take for example the ECB in 2011 trying to raise rates too early and the EU bonds selling off, or the US market nose-diving in December 2018 when the Fed raised rates too far, too fast (but now is reversing course).

Even our own RBA was forced to cut the Overnight Cash Rate, in June and July 2019 by 0.5% total, after the market had already priced in 75bp of cuts for 2019 calendar year.

Two more important secular drivers of interest rates are demographics and technology.

Simply, longer life expectancy increases demand for savings and fixed income streams, while new technologies are developed to save capital and improve efficiency. The result of this increased preference for fixed income has seen bond prices trend higher and “natural” rates of interest lower.

Time preference

A favourite saying of mine is "a bird in the hand is worth two in the bush". It was applied to financial markets for many a year to say that people always value today's consumption more than tomorrow's (future) consumption. Investors are displaying a positive time preference where they demand compensation in the form of higher return on an investment today in order to forego today's consumption.

This made sense in a world where communities only managed to enjoy retirement for 5 to 10 years on average before passing away, and therefore retirement savings were less valued. However, it can be argued now that where people are expected to live longer or live in retirement for longer, people demonstrate a negative time preference where they value future consumption during their retirement (or ability to have some consumption) more than current consumption. Ergo, they transfer today's purchasing power to the future and will accept negative interest rates in the near term to keep their savings balance intact.

The Bank of England produced a very interesting paper to break-down the contributions to lower interest rates by various drivers.

Of the approximately 4.5% decline of G10 bond yields in the last 10 years, the key drivers were:

  • Higher desired savings (-1.6%)
  • Demographics (-0.9%)
  • Lower public/government investment (-0.20%)
  • Asset Allocation to emerging markets over developed markets (-0.25%)

Turning Japanese

In essence, the market is predicting bond yields to remain low because:

  • Central bank monetary policy that has promoted negative yields are preparing to continue to employ an easing bias, despite negative rates already in existence
  • Inflation is likely to stay low because of negative time preference and technology
  • The price of labour continues to fall with advances in technology and supply-demand dynamics
  • Quantitative Easing (QE) is not working to reverse disinflation
  • Debt levels remain high

Japan's experience over the last 20-30 years is a struggle with high debt levels and low inflation and has experimented with low/negative interest rates and QE for the longest of any economy, to no avail. For the bond market, "Turning Japanese" means lower yields for longer, and flatter yield curves.

When Fixed Income becomes Fixed Expense

Negative yields do not inhibit investment as much as one would think. Paying a borrower (bond issuer) is not considered irrational investing when the security's price is expected to rise, aka bond yields are expected to become more negative.

Take for example the originally mentioned 10y German Bund.

It has appreciated 8.23% YTD despite having a 0% coupon.

Money continues to chase price appreciation in a global economy where central bank stimulus is becoming the go to monetary policy strategy.

If central banks are trapped into continuing to cut interest rates in hopes of increasing inflation, then the current yields can well become negative or more negative, but this won't necessarily stop wall of money investing in these bonds. 

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