Extraordinary Financial Markets
Pramit Ghose
Pramit Ghose

Around mid August, the yield on the US 10-year bond fell below that on the 2-year bond for the first time since 2007.  Why should you care? It means bond investors are concerned about the longer-term health of the US economy, pushing longer-dated bond yields down. Historically, this yield curve “inversion” has been a reliable indicator of a (US) recession.

This had the effect of spooking equity markets at the time. So the bond market is telling us the US will have a recession soon, but of course that doesn’t necessarily mean there will be one, with some strategists saying it’s just the weight of money buying longer-term US bonds. According to Goldman Sachs, following the past five inversions, the US entered a recession an average of 22 months later while the S&P 500 suggests an average 12-month total return of +12% (see table below).

S&P 500 Returns Following 10y-2y Yield Curve Inversions (%)

Inversion3m6m12m24mTime To Recession
Aug '78 (11) (6) 1 16 18 months
Dec '88 6 18 25 16 20 months
May '98 (1) 5 25 34 35 months
Feb '00 4 3 (5) (18) 14 months
Dec '05 4 (0) 13 17 25 months
Median 4 3 13 16 20 months
Average - 4 12 13 22 months

Source: FRB and Goldman Sachs Global Investment Research

So what is the lesson here? Perhaps to be cautious and prudent, but not to panic.

Any of us that grew up in (or worked through) the 1970s/1980s will remember inflation. I remember my father saying in the mid 1970s that with inflation at 20%+ and deposit rates in the low teens, “what’s the point of saving? Let’s spend!”. In 1982, the Irish 10-year bond yielded 19.82% for a while, so the current environment of very low bond yields is challenging for investors to navigate. It seems an insane concept that investors are buying negatively-yielding bonds in their droves, that they are making an investment guaranteed to lose money if held to maturity. But this has become a fact of life in bond markets, with more and more bonds negatively yielding. Bonds worth over $15 trillion, about 25% of government and corporate bonds in issuance globally, are negatively yielding now.

Put simply, that means bond prices are so high that investors are guaranteed to get less back in interest and capital repayments than they paid if held to maturity – investors are in effect paying someone to look after their money.

How have we arrived at this extraordinary situation? Weak economies and low inflation have driven central banks to try to stimulate economies, by setting official interest rates at low or negative levels. Central banks are also engaging in Quantitiave Easing (QE), the purchasing of bonds from financial institutions to push more money into the “system”. Regulators have insisted that the liabilities of insurance companies and pension funds be matched by having higher bond exposures, thus pushing up bond prices, and pushing bond yields lower. Investors are buying bonds in a hunt for relative yield, which is also contributing to the push down of yields. If a central bank sets a base rate of -0.4%, a yield of zero on an ultra-safe government bond might seem attractive.

If you lend 1,000 Swiss Francs to Switzerland today for 10 years, you will get back just 910 Swiss Francs in 2029! (source: Bloomberg)

It’s clear that bonds are very expensive now, maybe in a ‘bubble’ – there is no precedent for bonds this expensive.

If one had been prescient enough to buy the 100-year bond issued by Austria in September 2017 (at a yield of 1.75%), you would now have almost doubled your money! Investors buying this bond today are locking in a yield of just 0.7% for the next 98 years!

It makes me wonder how much “investment” into negatively yielding bonds are speculative short-term trades looking for a quick capital gain with no intention of holding the bonds to maturity?

On the other hand, bond optimists will tell you otherwise, that yields will keep falling as western economies are heading for a slowdown and that central banks will have no choice but to keep cutting rates and printing money. If you believe this, the world is going into recession, and negative interest rates for your bank deposits will become a reality for a long time.

It’s not just deposit rates and government bonds that are in negative yield territory. The search for yield recently saw Swiss food giant Nestlé become the first company with 10-year euro debt to yield below zero, with others looking poised to follow.

Perhaps it is no surprise that Nestlé is the first company to achieve this. It is after all a very strong and stable company, so investors are happy to lend to it. But this means that investors are paying Nestlé to mind their money for 10 years, it’s extraordinary!  Nestlé is being paid to borrow money interest-free for 10 years, money they can use to improve their businesses, pay dividends and make acquisitions. It’s a massive competitive advantage. If the bond market thinks Nestlé is such a wonderful company that it’s happy to pay it to take their money for 10 years and allow it to invest in money-making investments, higher dividends and share buybacks, then shouldn’t we invest in the shares of Nestlé? Even with the shares up some 30% this year, they have a dividend yield of 2.3% which is likely to keep growing over the next 10 years. Nestlé is a holding in our Global Equity Income portfolios.

Our take is that this extraordinary level of negatively-yielding bonds suggests investors are very concerned about a global slowdown/recession, and certainly there are plenty of things to worry about – but perhaps the actual yield levels of negatively yielding bonds indicate markets are overly pessimistic.

Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.

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