What is keeping negative bond yields from reaching the U.S.?

The Fed is not expected to go negative, but global market forces will continue to drive U.S. yields lower

Sep 25, 2019 @ 1:41 pm

By Jeff Benjamin

For the most part, U.S. fixed-income investors shouldn't be too concerned about the negative bond yields seen overseas reaching domestic markets. But even if the U.S. bond market avoids the negative-yield trend, as is expected, financial advisers will need to up their game when navigating the new world of fixed-income investing.

With more than $15 trillion worth of bonds in Europe and Japan generating unprecedented negative yields, fixed-income experts and market watchers are admittedly only able to estimate the ultimate impact on the global financial markets.

"Negative yields leave a lot of us scratching our head, and it is certainly a much-discussed topic," said Lyle Minton, chief investment officer at Keel Point.

"I'm an old fixed-income trader in a prior life, and I've never seen an environment like this," Mr. Minton said. "It's totally uncharted territory."

The uncharted territory dates back five years to when Japan and parts of the eurozone dropped interest rates to negative territory to try and stimulate economic growth. It is an extreme example of lowering rates to encourage borrowing, spending and allocations to riskier assets.

In Germany, for example, the 10-year bund, which is comparable to the U.S. 10-year Treasury, is yielding negative 60 basis points. That means investors are paying to own the security.

And investors are doing exactly that for several reasons, including fears that individual countries will be exiting the European Union.

"If you're living in Greece or Italy and have accumulated wealth and you're watching the eurozone Brexit, you are worried about your assets being converted to drachma or lira, so you buy the German bund and it's costing 60 basis points, but you're buying insurance," said Gautam Khanna, senior portfolio manager at Insight Investment.

"The eurozone is still being considered an experiment to this day," Mr. Khanna added. "If you own liquid Italian assets and are worried that politics could lead Italy to be the next country to call for an exit, you don't want to run the risk of having euros being exchanged for Italian lira, because you could lose 30% or 40% of your value."

In addition to investors playing defense against political uncertainty, the negative-yielding bonds are also being purchased by institutional investors that are mandated to hold a certain amount of government debt.

There are even passive index funds, such as the Vanguard Total World Bond ETF (BNDW), that are tracking benchmarks that are 26% weighted in negative-yielding bonds.

Moving up the sophistication ladder, there are also tactical traders betting on the direction of negative bond yields, as well as traders taking advantage of currency hedges.

Beyond their limited use as financial instruments, negative-yielding bonds so far have done a poor job of stimulating economic growth, which is one reason analysts don't expect the Federal Reserve to adopt similar policies.

"Negative rates have proven less than effective because they undermine the banking system crucial to creating economic activity," said Scott Kubie, senior investment strategist at Carson Group.

"For investors responsible for their own retirement, the logical response [to negative rates] is to save more and spend less," he said. "They create incentives for some individuals to do the opposite of what negative rates are trying to create."

Even though the Federal Reserve has cut rates twice this year, the current 2.25% rate is a long way from negative.

But analysts are keeping close watch on U.S. bond yields, including the yield on the benchmark 10-year Treasury, which is currently at about 1.7%.

"In our view, it is unlikely U.S. rates will follow their European counterparts into negative territory, but we have been believers in the low-for-long story," said Chris Nicholson, vice president of product management at PGIM Investments.

"We think U.S. policy makers are hesitant to try negative rates because its success in Europe could be questioned, and it causes problems in the banking system," he said, citing the extreme example of an adjustable-rate mortgage in Denmark that resulted in the borrower receiving monthly payments from the lender.

"I wish I could figure out a way to take out a mortgage in Denmark," Mr. Nicholson joked.

While the Federal Reserve might be resistant to introducing negative yields, it can do little to prevent demand from overseas from pushing U.S. yields lower as global investors pursue positive yields.

"The Federal Reserve has been much less keen on negative rates, but I wouldn't completely exclude that as a possibility," said Ella Hoxha, senior investment manager on the global bond team at London-based Pictet Asset Management.

"This all means U.S. Treasuries become very attractive, and the flight to quality can depress Treasury yields," Ms. Hoxha said. "What bond markets are telling you is that the expectations for growth are so depressed, hence the growth prospects have diminished. And given that expectations are so weak, my sense is it could get a lot worse."


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