Fixed Income Perspective: Hawks, Doves and Greater Fools

August 27, 2019

A recent big pullback in the prices of riskier investments has led to an unprecedented global-bond rally as investors sold out of stocks and sought safety.

  • The Federal Reserve’s July interest rate cut (the first since 2008) was characterized by the central bank as a recalibration, rather than the start of a long cutting cycle. 
  • However, the sharp repricing of global assets suggests that investors expect the Fed and other central banks to remain dovish by buying bonds and cutting interest rates further.

Slowing global growth, an escalating trade war, emerging-market political risk and a less-accommodative-than-anticipated Federal Reserve (Fed) have conspired to generate a sharp pullback in the price of riskier investments. This has led to an unprecedented global bond rally as investors have sold out of stocks and searched for safety. Exhibit 1 shows that the yields on global government bonds (the most conservative/least risky investments) have raced lower as buyers have driven up prices (yields move lower when prices move higher).

In the past month, yields on bonds issued by the governments of Canada, France, Germany, Italy, Japan, the U.K. and the U.S. (collectively referred to as the G7 countries) fell by an average of 35 basis points in just the last month. This is a truly large move by bond-market standards. U.S. Treasurys have embraced their role as the ultimate perceived safe-haven assets, leading the move lower with yields on 10-year Treasurys sliding by more than 50 basis points.

Exhibit 1: U.S. Treasury bonds lead global yields lower

Chart 1: Exhibit 1: U.S. Treasury bonds lead global yields lower

Exhibit 2: Record-low yields for both the U.S. and Germany

Further indication that animal spirits in the investment world have shifted to pessimistic extremes is the “lower yields forever” mentality that has taken hold. This is reflected in the sharp flattening of global yield curves as long-term interest rates have tumbled. In the U.S., we witnessed this as the 10-year/2-year Treasury yield curve inverted. For the first time since 2006, investors could earn a higher yield on a two-year investment than they could by locking their money up for a decade. We also saw a new record-low yield (1.95%) set for the 30-year Treasury bond.

Across the pond, European bond yields drifted further into negative territory as the German 30-year fell below 0% for the first time (Exhibit 2). Inflation markets also pointed to extreme pessimism with the U.S. Treasury inflation protected securities (TIPS) 10-year real yield moving into negative territory as breakeven inflation rates cratered to multi-year lows.

Exhibit 2: Record-low yields for both the U.S. and Germany

Chart 2: Record-low yields for both the U.S. and Germany

Source: Bloomberg, SEI. Data as of 8/15/2019.

A hawkish cut = wasted ammunition

The sharp repricing across global assets suggests that investors believe central banks will continue to take a dovish stance by buying bonds, cutting interest rates and taking other steps to provide economic stimulus. Yet we are skeptical as to whether or not there is enough monetary dry powder to get us through the next cyclical economic downturn. The latest actions by the U.S. Federal Open Market Committee (FOMC) underscores these concerns.

At the July FOMC meeting, the federal funds rate (the interest rate banks pay when making overnight loans to other financial institutions) was cut for the first time since 2008. The 25 basis-point cut was largely in line with market expectations. But the Fed’s messaging during the post-meeting press conference was hawkish—in other words, less accommodative than anticipated. Fed Chairman Jerome Powell characterized the rate cut as a mid-cycle adjustment, rather than the start of a lengthy cutting cycle. Investors didn’t like the tone of that message. In response, riskier investments sharply sold off and investors bought U.S. Treasury bonds—a clear indication that markets viewed this as a policy mistake. This initial move was quickly amplified as an unexpected escalation in U.S./China trade war rocked global markets.

Prior to the FOMC’s July meeting, bond prices showed that investors expected a year-end federal funds rate of 1.85% (roughly equal to two expected cuts in 2019). Post-meeting, markets quickly re-priced to a year-end expected federal funds rate of 1.45%, or about three total cuts for the year (Exhibit 3). Thus, markets have completely rejected the Fed’s hawkish stance and have priced in a full additional cut by year end.

Exhibit 3: The Fed’s cut failed to appease investors

Chart 3: Source: Bloomberg, SEI. Data as of 8/15/2019.

Source: Bloomberg, SEI. Data as of 8/15/2019.

Given that the federal funds rate topped out at just 2.5%, the Fed only has a total of nine 25-basis point cuts at its disposal before rates hit the lower bound of 0%. The irony is that the Fed essentially neutralized its first cut with its disappointing messaging. Given the limited capacity to cut rates, this may come back to haunt the central bank.

Greater Fool theory

The recent drop in yields has resulted in $16 trillion dollars’ worth of negative-yielding debt worldwide. Negative yields run counter to all economic intuition. The only way for non-currency-hedged local investors (in other words, most citizens in most countries) to break even—let alone earn a positive return—is to sell the bonds for a higher price than what they themselves paid for them.

The major difference this time around is that the greater fools in the bond market are global central banks.

Economists call this the Greater Fool approach. This theory states that an investor can profit from buying securities (no matter how overvalued) simply because there will always be someone (the bigger fool) willing to pay an even higher price for them down the road.

History is littered with cautionary tales of this approach—think of the dotcom bubble or the U.S. housing bubble. The major difference this time around is that the greater fools in the bond market are global central banks. The four largest central banks (Fed, European Central Bank, Bank of Japan and Bank of China) have a collective $20 trillion of buying power at their disposal (Exhibit 4).

Central banks have a completely price-insensitive economic objective. They buy in hopes of stimulating economic activity, not to generate investment returns. As long as the quantitative-easing floodgates remain open, it’s not a stretch to expect that someone (a central bank) will buy your bonds back at a higher price.

Exhibit 4: $20 trillion of global central-bank buying power has contributed to $16 trillion of negative-yielding debt

Chart 4: $20 trillion of global central-bank buying power has contributed to $16 trillion of negative-yielding debt

Source: Bloomberg, SEI. Data as of 8/15/2019.

The trade war remains a fluid situation with little chance of near-term resolution.

Our view: where do we go from here?

Previously, we said that if conditions deteriorated to a degree that required an interest-rate cut, we believed that the 10-year Treasury would trade down in the 1.50% to 1.75% range. The post-FOMC rally has quickly driven markets to the lower end of our expected range. Given the velocity and magnitude of that rally, we think the market will likely consolidate in this range as we await further clarity on both the trade-war and monetary-policy fronts.

The trade war remains a fluid situation with little chance of near-term resolution. At the Fed's annual Jackson Hole symposium, Fed Chairman Powell reiterated the central bank's commitment to supporting the economy. While acknowledging geopolitical turbulence, he did not commit to making deep rate cuts. Beyond this, there are scheduled policy meetings for the European Central Bank, the Fed and Bank of Japan on September 12, 18 and 19, respectively. Given the elevated downside risk, the sharp tightening of financial conditions and limited monetary capacity, there is a clear impetus for global central banks to collectively deliver a dovish message to markets. If central banks fail to deliver (or if there is further trade-war escalation), the rally is likely to extend with scope for the 10-year Treasury to test its all-time low yield of 1.35%.

Aside from the aforementioned risk, we believe the relative yield advantage of Treasurys makes them more attractive than global government bonds—over half of which now offer a negative yield (Exhibit 5). Treasurys account for 65% of all outstanding government bonds that offer a positive yield. Given that they account for only 30% of total market value, Treasurys are punching well above their weight in terms of yield contribution. Facing this dearth of positive-yielding assets, the U.S. bond market should remain attractive to foreign flows, which should keep prices high and yields low.

Exhibit 5: U.S. Treasurys are more attractive than global government bonds

Chart 5: U.S. Treasurys are more attractive than global government bonds

Universe = Bloomberg Barclays Global Aggregate Government Index. Source: Bloomberg, SEI. Data as of 8/15/2019.

We think the 1.50% to 1.75% 10-year Treasury yield range will likely hold in the near term. However, we see the risks as skewed to favoring lower yields. We would caution against fading the recent rally and view any back-ups to the higher end of this range as an opportunity to add to our duration exposure.

Glossary of Financial Terms

Breakeven inflation: Breakeven inflation rate is a market-based measure of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.

Duration: Duration is a measure of risk in bond investing and indicates how price-sensitive a bond is to changes in interest rates. A long (overweight) duration stance indicates the portfolio duration is higher than that of the benchmark whereas a short (underweight) duration stance indicates a lower duration. Duration is measured in years and securities with longer durations are more sensitive to interest-rate changes.

Nominal yield: Nominal yield refers to the interest rate stated on a bond when it is first issued.

Real yield: Real yields have been adjusted to take into account the impact of inflation. Real yields are calculated by taking the nominal bond yield (interest rate stated on a bond when it is first issued) minus the current rate of inflation.

Index Definitions

The Bloomberg Barclays Global Aggregate Index, an unmanaged market-capitalization-weighted benchmark, tracks the performance of investment-grade fixed-income securities denominated in 13 currencies. The index reflects reinvestment of all distributions and changes in market prices

The Bloomberg Barclays Global Treasury Index tracks fixed-rate, local-currency government debt of investment-grade countries, including both developed and emerging markets. The index represents the treasury sector of the Global Aggregate Index and contains issues from 37 countries denominated in 24 currencies.

Legal Note

Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.

There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as interest rates rise.

SEI Fixed Income Portfolio Management is a unit of SEI Investments Management Corporation. Information provided by SEI Investments Management Corporation.