Rates Also Rise
Hardly a day passes without one of the world’s leading equity indices hitting new all-time highs. If it isn’t the S&P 500, it’s the German Dax — and if it isn’t an all-time high, then it’s at least the highest that index has been in many years, whether it’s the American Nasdaq or the Japanese Nikkei.
In tandem, and closely linked, is the phenomenon discussed last week, of ultra-low short-term interest rates in developed economies. After being held for years at or near zero, they are now being pushed to and through the ‘zero bound’ in response to very low inflation almost everywhere. Negative interest rates led almost inevitably to negative yields on short-term government bonds.
The negative yield phenomenon used to exist only at the very short end of the yield curve, for bills of three, six or perhaps twelve months’ duration. But over the last year or two, under the impact of huge QE programs undertaken by the central banks of Japan and now the eurozone, negative yields have extended much further out — to maturities of two, five and even seven years.
In the case of Switzerland, the desire to hold Swiss assets has turned the yield curve on Swiss government bonds negative all the way out to ten-year maturities.
Germany and Japan were not far behind, to the point that in December the two countries’ 10-year government bonds seemed locked in a race to see which could reach a higher price and hence a lower yield. In the case of ten-year JGBs (Japanese government bonds) the yield sank below the previous record low level of 0.31% per annum — recorded very briefly in 2013 — and went on to reach 0.2%. At one point, the yield on the 10-year German ‘bund’ was actually lower than that of the parallel JGB, but the German bond stalled out at a yield of 0.27%, so the Japanese may be said to have ‘won’.
Those extremes were recorded around the turn of the year. Other countries were part of the same phenomenon, although not to the same extreme extent. The US Treasury 10-year bond, arguably the single most important financial asset on the planet, had seen its yield fall throughout 2014: after hitting a high of just over 3% per annum at the beginning of that year, it fell below 2.5% during the summer — and the decline picked up steam toward the end of the year, in line with the global trend.
When the German and Japanese bond yields were hitting bottom in early January, the American bond crossed the 2% level, but it kept going down much longer. By the end of January, the yield was down to almost 1.6% and approaching the record, all-time low of 1.39% recorded in the summer of 2012 — then, as now, against the background of a crisis in the Eurozone.
But whoever bought the 10-year Treasury at that peak level is not a happy person today — because, in the last few weeks, that yield has snapped back by 50 basis points or half a percentage point, to a high of 2.16% on Wednesday of this week. His Japanese counterpart is even less happy, because the yield on the 10-year JGB has almost doubled, from 0.2% to 0.4%. The German yield has also risen, albeit less dramatically.
So what? The reason this is actually important, rather than merely remarkable, is twofold. The lesser reason is that this is another example of the phenomenon of massive volatility discussed here a couple of weeks ago. Extreme volatility is bad in any market, but it is especially unwelcome in government bond markets, because they are supposed to be stable and liquid. What has happened in recent weeks and months is disturbing evidence that they are precisely the opposite — and if the government bond markets are illiquid, then the state of the rest of the financial system can only be much worse. That is highly disturbing, to say the least.
However, there is an alternative scenario of how this might develop, compared to which the prospect of continuing severe volatility is almost desirable. That is for yields to continue to rise. If the underlying demand for government bonds is falling — for whatever reason — then even the huge buying programs of the central banks may not be sufficient to maintain the current extreme levels of prices and yields.
If investors demand higher yields to hold medium- and long-term paper — and, given the weak finances of every developed country, that would be a very sensible thing to do — then yields will continue higher. Not necessarily at the recent pace, but over time we will see 10-year Treasuries back at 2.5% yields, and then 3% and perhaps higher.
As for Japanese government paper, were it not for the Bank of Japan’s commitment to keep buying, the yield would be much higher — perhaps even 1%. That doesn’t sound much but, given the sheer volume of Japanese government debt, a significant rise in the government’s interest bill could push it over the brink into bankruptcy.
So pay less attention to the record highs in equity markets and, instead, keep a close watch on the once-boring, now-terrifying, government bond markets.