Recent financial headlines have focused on the impact of Zero Lower Bound and negative interest rates. The Zero Lower Bound signifies that nominal interest rates are at or below zero and that particular investment yields are effectively negative. For investors, this translates to bank deposits and holding bonds to maturity returning less capital than the face amount of the original investment.
In past weeks, investors have witnessed a severe drop in global bond yields, resulting in claims that the bond market has officially entered a “financial twilight zone.” While zero or negative yields rarely result in investors paying to hold bonds, they symbolize the premium that investors are willing to pay to hold onto financial instruments that are perceived as safe investment channels.
Yields are driven by the inflow and outflow of funds. Recent risk-off sentiment has been spurred by a myriad of events, including the ongoing US-China trade war, anemic growth in the Eurozone and Japan, and the Saudi oil attack. In times of economic uncertainty, government bonds have historically been the preferred investment channel and, as such, seen an influx of funds. As the demand for government bonds grows, prices rise and yields drop.
According to Bank of America Merrill Lynch Global Government Bond Index’s latest print, negative-yielding government debt worldwide has accounted for approximately one-third of tradeable bonds across the globe – its highest level since October 2016. Markets like Japan and the European Union combined have more than USD 13 trillion of negative yielding bonds, according to data from the Institute of International Finance. Because a significant portion of bond market yields are negative, finding attractive positive returns can be challenging.
Market Value of Negative Yielding Bonds by Region (USD trillion)
Sources: Institute of International Finance, Assured Asset Management
10Y Government Bond Yield Performance by Country(in %)
While negative yields have emerged in the past, their scale has significantly increased in recent years. This is particularly due to quantitative easing policy by central banks as well as macroeconomic uncertainty.
Central banks worldwide closely monitor inflation as a precaution for economic health. When nominal interest rates approach zero or below, investment and consumer spending become difficult to stimulate through rate cuts and monetary policy loses its efficacy. Japan is perhaps the most well-known example of this “liquidity trap.”
When nominal interest rates reach lows, central banks typically adopt Quantitative Easing (“QE”) measures to stimulate the economy by pumping liquidity into financial markets. Currently, the Fed, ECB and BOJ are implementing QE by manipulating money supply to pursue economic growth and inflation targets. However, excess market capital has flowed into risk-free assets like government bonds, which has subsequently cut yields to all-time lows. In addition to Japan, several European countries including Germany, Sweden, Austria and France have all fallen into the liquidity trap and inherited negative yields. Poignantly, there are even mortgage products in Europe that boast negative interest rates.
This has led to a campaign from global capital to seek attractive positive yields.
Japan GDP YoY and 10Y Government Bond Yield(in %)
The US economy remains healthy
Does QE work? The answer is unclear. The US economy has moderately recovered from 2008 lows; however, many other major economies have continued to lag.
Markit Manufacturing PMI
European Commission Consumer Confidence
Japan Consumer Confidence
The pursuit for yields has steered global capital into US bond markets. Bond yield spreads between the US and the rest of the world are still wide, despite US intentions for rate cuts in the coming months. Because US government bond yields remain positive (particularly amongst this year’s inverted yield curve), US assets remain an attractive asset class for foreign capital seeking positive yields. Since August, however, US bond markets have recorded substantial inflows that have brought USTreasury yields to historical lows.
The US economy has shown no signs of recession and is still performing strongly, despite slowing growth momentum. The consumer sector, which accounts for two-thirds of US GDP growth, is still healthy, indicating that consumer vitality continues to sustain economic expansion and support the country’s GDP growth.
Furthermore, consumer sentiment remains bolstered by solid labour market performance. The participation rate of the labour force in August increased to 63.2% while the employment-population ratio rose to 10-year highs of 60.0%. These overall healthy economic figures have contributed to strong yields which in turn have made US markets a top global investment opportunity.
US University of Michigan Consumer Sentiment Index
US Unemployment Rate and Labor Participation Rate (in %)
Investor impact of risk-off market sentiment
Yields are investor compensation for assuming investment risk. The risk-reward payoff is a central factor of consideration that drives the investment process; however, recent macro liquidity movements have lowered global yields and revalued asset risk profiles, thus rendering institutional investors like banks, insurance companies and pension funds increasingly overexposed to risky events and market volatility. Furthermore, near-zero funding costs encourage leverage and riskier investment activity which, in the long-term, will create speculation and misalignment of asset risk-reward profiles. For investors, this equates to higher financial market volatility.
Global economic recovery is unbalanced and, with major markets at varying points of quantitative easing, Zero Lower Bound and low yields have become the new normal. Investors must take caution as those with limited access to a diverse range of financial products will be the most strongly impacted by current liquidity flights. Portfolio diversification across asset classes is crucial when navigating amongst a negative rate environment and provides potential for boosted returns and minimized investment volatility.
Going forward, investors must prepare themselves for the possibility of a world with lower yields. It remains our advice to steer capital into investments that provide the best yields at preferred risk levels within current market conditions.