Falling government bond yields were in the spotlight last week as 10-year German bund yields dipped below zero for the first time ever and 10-year US treasury bond yields fell below 1.6 per cent for the first time since 2012.
UK Gilt yields also slid to just 1.1 per cent as heightened Brexit concerns reinforced fears about global growth and about the prospect of market instability in the event of it happening. Yields managed to pull back from their lows at the end of last week, but this improvement hardly represents a significant reverse, and the likelihood is that yields could fall further still especially if the Leave campaign in the UK referendum wins this week.
However, the falling yield story is not just about Brexit, as yields have been declining now more or less consistently over the course of the past few years. There are a number of other cyclical factors that have been weighing on bond yields, but there are also some structural factors that are contributing as well.
On the cyclical side, the main argument is that weak global growth is causing yields to crumble, with the recent appearance of doubts about the strength of the US economy being a catalyst for further bond yield declines. This coincided with renewed warnings from the World Bank about the strength of the world economy, as it downgraded its 2016 global growth forecast and cited “sluggish growth in advanced economies, stubbornly low commodity prices, weak global trade, and diminishing capital flows”.
Alongside these concerns about global recession and deflation is the increasing preponderance of negative interest rates in Europe and Japan which provide a kind of “gravitational pull” to global bond markets, with approximately US$10 trillion of negative-yielding bonds in circulation today.
However, it seems unlikely that these cyclical arguments are the whole story. For one thing the World Bank’s pessimistic outlook is by no means universally shared. It seems unlikely that the United States is heading back into recession, despite recent job market weakness, and global growth in 2016 so far looks like it is improving especially in Europe and Japan. Also, weakness in bond yields and pessimism about growth appear to fly in the face of higher levels in equity markets, which under normal circumstances would put upward pressure under yields.
There are, though, other structural factors that are also serving to suppress bond yields, reinforcing cyclical issues, as fleeting and potentially unreliable as these may be.
Beside policy rates, sovereign yields get impacted by their own demand and supply dynamics. Currently demand for sovereign assets is particularly high. After all, quantitative easing is ongoing in the euro zone and Japan, where the ECB and BoJ are some of the biggest buyers of their countries’ supply of sovereign debt. Furthermore, the supply of US treasuries and German bunds is expected to be low in the coming few years as deficits are likely to remain contained. So, with increasing demand and decreasing supply, the risks for bond yields are structurally biased lower.
Furthermore, the global banking system is undergoing structural reforms that require banks to have more capital invested in risk-free liquid assets, which also underpins demand for sovereign bonds. Pension funds are also becoming bigger contributors to the investable capital in the world and they generally prefer investment in safe assets. Central banks across the globe have also been beefing up their FX reserves to hedge against external vulnerabilities such as the ones faced by the Asian countries in late 1990s.
However, before getting carried away thinking that bond yields will only ever go down, there are also arguments that might yet serve to push them back up. For one thing, patience with negative interest rates appears to be wearing thin. A large German bank last week threatened to take its cash away from the ECB, while another German bank published a heavily critical note of ECB policy, arguing for a return to positive interest rates. The Bundesbank estimates that negative rates cost German banks €248 billion (Dh1.02tn), and the BoJ also appears reticent to push interest rates further into negative territory. The bond king Bill Gross of Janus Capital has also recently warned that the $10tn stock of negative-yielding sovereign bonds is a “supernova that will explode one day”. One day probably, but maybe not just yet.
Tim Fox is the chief economist and head of research at Emirates NBD.
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