The race to zero
This is a fascinating time for fixed income markets and 2019 could well turn out to be quite a milestone. The key question for investors at the moment is whether we are witnessing a mid-cycle slowdown or an end-of-cycle slowdown; given what we are seeing from a macro perspective we believe it is the latter.
The universe of negative yielding bonds has reached $12 trillion. This phenomenon is not just confined to government bonds, it has also begun to take hold in the corporate bond market where over $500bn worth of bonds trade with a negative yield. There is even some negative-yielding debt to be found in certain emerging market sovereigns. Globally, as much as 7-8% of the 10+ year maturity bucket is now trading on yields of below zero, so the negative yields don’t just apply to short rates either.
Central banks are getting nervous
Central banks have adopted an increasingly dovish stance as they have become nervous about the inflation outlook, with several having undershot their inflation targets for quite some time. In the US, core inflation has been averaging about 1.5% versus the Federal Reserve’s (“Fed”) target of 2%. The European Central Bank (“ECB”) has similarly failed to hit its 2% inflation target on a sustained basis. While UK inflation has been more persistent, averaging slightly above 2% at the core level, much of that has been driven by the weakness in sterling, pushing up import prices. In Europe, 5-year inflation swap levels have fallen significantly, with recent comments by ECB president Mario Draghi indicating the ECB could soon resume quantitative easing. In the US, the Fed appears primed to ease monetary policy in an effort to combat falling inflation expectations and intensifying global economic headwinds.
It’s also interesting to note that a strong correlation has developed between the quantity of negative-yielding bonds and the price of gold. The price of gold has risen as negative bond yields have become more prevalent, with participants in both markets positioning for another round of aggressive monetary easing from central banks.
Whilst a proportion of the decline in global bond yields has been driven by the trade war, we believe the extent to which the Fed has tightened policy is the key factor driving the slowdown and in turn pushing yields lower. Since late 2016, the Fed has raised interest rates on nine occasions alongside reducing its balance sheet (“quantitative tightening”). It typically takes 12 to 15 months for a rate hike to fully filter through to the real economy so, from where we sit, the full impact from the Fed’s three rate hikes last year is yet to fully manifest itself. In terms of current interest rate expectations, the market is pricing in approximately two Fed rate cuts by the end of 2019. However, we think there could be three or more rate cuts because we don’t expect the economic data to recover in the second half of this year. We also believe there could be a further three rate cuts next year, whereas the market is only pricing in one rate cut for 2020. US Treasury yields fall sharply over the course of rate cutting cycles as we highlight in Figure 3. For this reason, we continue to be bullish on US Treasuries and other developed bond markets despite the big rally we have had year-to-date.
Is a recession on the cards?
Global purchasing managers’ indices (PMI) have fallen into contraction territory, with around 60% of individual country PMIs having slipped below the 50 level that separates expansion from contraction. Typically, when the percentage of countries reporting PMIs below 50 reaches around 75%, there is a global recession. In the US, there have been initial signs of weakening in the jobs market from private surveys of small businesses and the US non-farm payrolls monthly data has become more volatile; so far this year we have witnessed the two weakest non-farm payrolls of Trump’s presidency. Despite being a lagging indicator, we believe it’s worth paying close attention to the jobs market as any material deterioration would provide confirmation of our end of cycle thesis. (...)