MUNIX COMMENTARY – July 29th
The calm before the storm, or still waters run deep?
Bond markets have shown little movement in the past week, consolidating after the ructions earlier in July. This may be the calm before the storm later in the year, or an example of how central bank policies in some areas considerably restrain policies in others.
The focus of attention for investors this week was the release of the minutes of the latest Federal Reserve meeting and subsequent explanatory comments from Fed Chairman Powell. To no great surprise, there were no surprising announcements. The Fed confirmed what everyone knew, that the US economy is slowly returning to better health. Indeed the second quarter GDP release indicated that output has finally returned to its levels seen before the pandemic. Against that background, the Fed indicated that later in the year it would consider whether to taper, that is reduce, its purchases of bonds. The consensus view is that the Fed will examine the issues in September and act in December – so the next question is how quickly will tapering happen. This in turn will partly depend on growth and inflation statistics into the autumn, as well as two political issues. One is the detail of the infrastructure package which the Senate has agreed. The headline figure of $1 trillion is less important than the details of the tax increases, or debt issuance, which will be needed to finance it. The other issue which might cause market worries in coming months is the ceiling on debt finance; on some estimates the US Treasury will exhaust its ability to finance government activities in October or November unless Congress agrees to raise the ceiling.
US 10-year bond yields are currently about 1.25%, in Australia about 1%, in the UK about 0.6%, but in Japan they are close to zero and in Germany about minus 0.45%. Negative yielding bonds are a most peculiar aspect of modern bond markets. If we look at the yield curves of bonds issued by the Japanese and European governments, then many are at or below zero. Much of such debt is shorter maturity, out to 5 years, but in France it is negative past 10-year and in Germany the curve is negative out past 20 years.
If we aggregate all such negative yielding debt in the world it comes to a frighteningly large figure = $15 trillion. To put that into context, it would equate to about 70% of US annual income. Although the total amount of negative yielding debt was about $6-8 trillion in 2017-19, it surged in late 2020 to $18 trillion as bond markets reacted to the pandemic. While most debt has been issued by governments, about $1 trillion worth of corporate debt also has a negative yield. In effect, some investors are paying certain companies to issue debt!
It is important to recognise the implications of such negative yielding debt for many investors in Japan and Europe. Whilst some will be content to hold such bonds, benefitting at least from a certain return rather than the uncertainty of equity investments, others are forced to search for a positive yield in other global markets – especially as and when currency movements are favourable. Foreign exchange hedging is a complex issue, but periodically it is apparent that European and Japanese investors deliberately seek higher yielding bonds in Australia, Canada, the UK and USA, not to mention emerging markets such as China where yields are close to 3%. In effect such cross-border capital flows act as an anchor to the higher yielding markets. As and when the gap grows sufficiently wide, then a group of domestic investors will look overseas.
Real (or inflation adjusted) bond yields in the USA are in negative territory, signalling the degree of financial repression being carried out by the Federal Reserve. As and when growth, employment and inflation prospects allow, then the US central bank looks set to taper its bond purchases, allowing higher real and hence nominal yields – say back towards 2-3%. The UK and certain advanced economies such as Australia and Canada are generally expected to follow suit. However, a sustained deflationary backdrop in Japan and much of Europe will hinder the ability of their central banks to follow suit. All in all the sizeable amount of negative yielding debt in the
world means that the gap between yields in the USA, the UK or similar markets can not move too far apart from their much lower yielding cousins.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making