Why Negative U.S. Treasury Yields Might Become A New Normal

by: Michael Thomas


Long term trends have shown declining rates since 1981.

Growing amounts of sovereign debt around the world carry negative yields.

Fed Chair Janet Yellen has planted the seed for the idea of negative rates in the US.

Demand for the US dollar and dollar denominated debt is strong.

Tame inflation since the Great Recession adds more pressure for lower yields, and possible deflation.

Negative Rates

(source: armstrongeconomics-wp.s3.amazonaws.com/2...)

Long Term Trend

One of the most obvious and often used charts to tell the story of US interest rates is the one showing an unwavering slope downward since 1981. The start of the trend that began in 1981 when then Fed Chairman, Paul Volcker, raised the federal funds rate to combat rampant inflation has been in place ever since. Yields have been falling for almost as long as I have been alive and if the old saying "the trend is your friend" holds any merit, there's few trends in history stronger than the one seen with interest rates.

click to enlarge)US Note Yield 1981-present (CBOE Interest Rate 10 Year from 1981-present, source: Yahoo Finance)

As rates have continued to fall investors holding bonds have reaped major rewards in the form of capital gains since 1981. The first half of 2016 has proven to be equally rewarding with some of the most widely traded bond ETFs posting impressive gains.

iShares' popular long term treasury ETF (NYSEARCA:TLT) is up 19% year to date with Vanguard's comparable fund (NASDAQ:VGLT) up about the same at 18%. State Street Global Advisors' long term fund (NYSEARCA:TLO) also matches the 18% mark. Shorter duration funds have also fared well, albeit not quite as much. iShares' intermediate treasury fund (NYSEARCA:IEF) is up almost 8% on the year while their 10-20 year targeted fund (NYSEARCA:TLH) is up almost 11%.

Tresury ETF YTD Price Change

(Popular treasury ETF YTD price changes, source: Yahoo Finance)

Growing Amounts Of Negative Sovereign Debt

The amount of sovereign debt with negative interest rates around the world has been increasing rapidly. What was once a figure standing at roughly $1.3 trillion at the end of May, negative yielding sovereign debt has swelled to close to $12 trillion by the end of June. Governments around the world are succumbing to negative rates as the graphic below depicts.

click to enlarge)Global Sovereign Debt

(source: Katie Hill, ANZ)

With globalization inextricably connecting world economies, it seems only a matter of time before at least some United States sovereign debt turns negative. This transforms what used to be the standard mechanism for saving and risk free investment into nothing more than a speculative asset to be bought because the expectation is that yields will continue to decline.

Even recent debt offerings from countries that might otherwise garner much higher interest rates are only offering 2.13%, like that seen in the recent five-year notes debt offering by Qatar. Many Middle Eastern oil rich countries have been under extreme fiscal pressure as oil prices have exhibited prolonged weakness. In order to make up the difference (they actually care about balanced budgets) they have turned to debt markets after exhausting lending from local banks. One might think that a country in a region with major geopolitical concerns and an economy with limited sources of revenue (oil being the reason for the fiscal shortfall) would have debt yielding more than 2.13%.

Yellen Goes Gardening

Janet Yellen has already planted the seed for the idea of negative interest rates in the United States when she commented about them back in February.

"I wouldn't take them off the table but we would have work to do to make sure they would be workable" - Janet Yellen, February 2016

It doesn't matter that she later retreated from the idea in March.

"So what I would like to make clear is that this is not actively a subject that we are considering or discussing" - Janet Yellen, March 2016

The idea has been presented and allowed to percolate in investors' brains. The psychological impact slowly weaving and rewiring investors to become more comfortable with the idea works nonstop.

It probably doesn't matter in the end as it is becoming increasingly obvious that the Fed may have lost control of the current economic situation. It took years (9 years to be exact) for the Fed to raise the federal funds rate by a measly 25 basis points. What has been the result on long term market rates? The yield on 10 year notes has fallen almost a full percentage point. Are lowering rates again really go to provide anything other than the confirmation that a deepening credibility concern regarding the central bank is warranted?

click to enlarge)US Treasury Note Yield December 2015-present

(CBOE Interest Rate 10 Year from December 2015-present, source: Yahoo Finance)

Demand For The Dollar

The Bretton Woods agreement in 1944, which solidified the dollar's role in being the world's reserve currency, is helping drive yields lower. Being the world's reserve currency means there is always going to be demand for that currency. Demand for the US dollar is also provided by its continued high usage in global oil pricing, although there have been pushes by various nations to move toward other currencies. Strong demand for the US dollar also leads to strong demand for US dollar denominated debt. It's not coincidental that in times of uncertainty investors flock to sovereign US debt, as it is also backed by the world's most powerful military force.

click to enlarge)Global Currency Reserve Composition

(source: IMF)

Even though there are some questions surrounding the future status of the dollar as the world's primary reserve currency, it is currently the largest held reserve currency in the world. The IMF's SDR may eventually prove the be the biggest challenger to the dollar but for now it still reigns supreme.

Where's The Inflation?

Interest rates on government debt include an inflation premium to compensate investors for rising prices. The lack on any real inflation is a growing concern being so far into a bull market and supposed economic recovery. We are at or extremely near full employment, real wages haven't grown, and inflation has been very tame considering the explosive growth in the money supply since the Financial Crisis.

US Money Supply M0

(source: tradingeconomics.com; background image: www.meridianpeakhypnosis.com/wp-content/...)

The graph above shows the growth in the M0 money supply, the most liquid measure, as a direct result of Federal Reserve enacted quantitative easing. The term QE became a household name after the Great Recession and for those that don't know what it is, it's when central banks buy bonds held at member banks to inject more money into the financial system. The relationship between the Fed's quantitative easing programs and the money supply is apparent in the graph below.

Fed Balance Sheet

(source: tradingeconomics.com; background image: static.guim.co.uk/sys-images/Guardian/Pi...)

As can be seen, the central bank's balance sheet has grown in step with the money supply, which a rough calculation would be over a 400% increase. Reducing rates to increase lending and injecting the financial system with fresh capital is monetary policy implemented in textbook fashion. However, questions about inflation arise when the results are reviewed.

click to enlarge)US GDP 2008-present

(source: tradingeconomics.com)

GDP growth over the same time period reflected by the money supply data shows that US GDP grew only 22% over the last eight years or so, or about 2.7% annually. Similar exercises for wage rates and inflation show average annual increases of 2% both highlighting that wages are only keeping pace with inflation and real wages likely haven't changed. The chart below shows inflation levels for the United States and the world since 2008.

US versus World Inflation 2008-present

(source: IMF)

So a massive increase in the amount of money in circulation coupled with tepid growth, stagnant wages, and likely full employment has produced very low inflation. This somewhat contradicts common economic theory that larger quantities of money chasing the same level of goods tends to produce higher inflation.

Adding to the mystery is that unemployment under 5% is a strong indicator of full employment and a peak in the current economic cycle where inflation is supposed to be most prevalent. This leads to the question, where's the inflation? Of course it has to be noted that most economic indicators tend to have drawbacks like inflation typically excluding energy and food costs because of the price volatility associated with those items.

The takeaway for the argument on possible negative rates in the United States is that low inflation expectations add downward pressure on rates.

Possible Deflation

Income inequality may be providing the strongest indicator that deflation may well be in the cards for the United States in the near future. When aggregate demand falls and is unable to keep pace with current levels of production, deflation takes hold where you have fewer dollars chasing more goods and services. In the worst case a deflationary spiral can occur where a cycle of layoffs leading to further decreased demand leads to further layoffs and so on.

The copious amount of money injected into the financial system doesn't help ward off inflation when most of the money ends up in the hands of a few. The topic is reviewed in greater detail in an article I wrote earlier and a graph from that article below shows a relationship between income inequality and the most financially difficult periods experienced in United States history.

US Income Inequality 1917-2012

(source: Emmanuel Saez, Sept.2013; cartoon source: thecontributor.com/sites/default/files/b...)

A global deflationary spiral could prove devastating and deflation may be the bigger concern than inflation, something the central banks of the world are ill equipped to handle. The following graph shows the turmoil that took place shortly after the Federal Reserve was created in 1913 and the deflationary period that occurred during the Great Depression. The peak inequality of the late 1920s preceded this period.

US Inflation

(source: tradingeconomics.com)


Investors are finding it more difficult to navigate the boom and bust cycles seen in the markets and find yield. The recent trends in the safest investments are increasing providing negative yields, which causes investors to seek yield in other areas like stocks.

I recently debuted a publicly available portfolio deemed "The Most Boring Stock Portfolio on Earth" which was designed to enhance yield through options while using dividend paying stocks as a foundation. The portfolio currently yields an annualized return of 7.5% from option premium. It also sets the stage for potentially buying underlying dividend stocks at an average of almost 15% below current stock prices if a prolonged market pullback occurs. Interested readers can find more detail in the link provided above but the current portfolio positions are shown below.

Company Name Ticker Industry Put Strike Expiration Date Date Sold Option Length (days) Premium Received Option Requirement Annualized Yield Position Weight Current Stock Price Option Moneyness
BOK Financial Corp BOKF Banks $45 09/16/16 06/13/16 95 $49.34 $4,500.00 4.28% 4.07% $60.50 25.62%
CSX Corp CSX Transportation & Logistics $22 11/18/16 06/13/16 158 $42.34 $2,200.00 4.50% 1.99% $25.88 14.99%
United Technologies Corp UTX Aerospace & Defense $85 11/18/16 06/13/16 158 $116.34 $8,500.00 3.19% 7.69% $101.97 16.64%
Yum Brands Inc YUM Restaurants $65 10/21/16 06/13/16 130 $78.34 $6,500.00 3.42% 5.88% $84.31 22.90%
Ryder System Inc R Consulting & Outsourcing $45 11/18/16 06/13/16 158 $69.34 $4,500.00 3.60% 4.07% $62.12 27.56%
Fastenal Co FAST Industrial Distribution $37 11/18/16 06/13/16 158 $99.34 $3,700.00 6.31% 3.35% $44.72 17.26%
DeVry Education Group Inc DV Education $15 11/18/16 06/13/16 158 $135.34 $1,500.00 22.09% 1.36% $19.35 22.48%
VF Corp VFC Manufacturing - Apparel & Furniture $58 11/18/16 06/13/16 158 $199.34 $5,750.00 8.19% 5.20% $62.74 8.35%
Infinity Property & Casualty Corp IPCC Insurance - Property & Casualty $75 12/16/16 06/13/16 186 $294.34 $7,500.00 7.85% 6.78% $80.38 6.69%
Qualcomm Inc QCOM Communication Equipment $45 10/21/16 06/13/16 130 $76.34 $4,500.00 4.84% 4.07% $52.93 14.98%
T. Rowe Price Group Inc TROW Asset Management $65 10/21/16 06/13/16 130 $159.34 $6,500.00 7.04% 5.88% $71.59 9.21%
Polaris Industries Inc PII Autos $70 09/16/16 06/13/16 95 $219.34 $7,000.00 12.59% 6.33% $82.94 15.60%
Williams-Sonoma Inc WSM Retail - Apparel & Specialty $48 11/18/16 06/13/16 158 $314.34 $4,750.00 15.95% 4.30% $51.61 7.96%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/13/16 130 $14.34 $500.00 8.26% 0.45% $6.44 22.36%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/14/16 129 $67.96 $1,500.00 13.36% 1.36% $6.44 22.36%
Daktronics Inc DAKT Computer Hardware $5 10/21/16 06/16/16 127 $43.65 $1,000.00 13.06% 0.90% $6.44 22.36%
Gap Inc GPS Retail - Apparel & Specialty $17 12/16/16 06/13/16 186 $135.34 $1,700.00 16.22% 1.54% $21.63 21.41%
ONEOK Partners LP OKS Oil & Gas - Midstream $21 10/21/16 06/14/16 129 $24.34 $2,100.00 3.31% 1.90% $40.66 48.35%
Analog Devices Inc ADI Semiconductors $48 09/16/16 06/14/16 94 $49.34 $4,750.00 4.09% 4.30% $55.95 15.10%
Flowers Foods Inc FLO Consumer Packaged Goods $15 10/21/16 06/14/16 129 $24.34 $1,500.00 4.66% 1.36% $18.55 19.14%
Brinker International Inc EAT Restaurants $40 10/21/16 06/14/16 129 $89.34 $4,000.00 6.45% 3.62% $47.15 15.16%
Tiffany & Co TIF Retail - Apparel & Specialty $60 11/18/16 06/13/16 158 $294.34 $6,000.00 11.70% 5.43% $59.53 -0.79%
AmTrust Financial Services Inc AFSI Insurance - Property & Casualty $24 09/16/16 06/13/16 95 $84.34 $2,375.00 14.35% 2.15% $24.29 2.22%
Bunge Ltd BG Consumer Packaged Goods $50 10/21/16 06/16/16 127 $84.34 $5,000.00 4.92% 4.52% $57.96 13.73%
Dominion Resources Inc D Utilities - Regulated $63 10/21/16 06/16/16 127 $54.34 $6,250.00 2.52% 5.65% $77.47 19.32%
Target Corp TGT Retail - Defensive $65 10/21/16 06/13/16 130 $257.34 $6,500.00 11.52% 5.88% $70.09 7.26%
TOTALS 138 $3,076.77 $110,575.00 7.52% 100.00% 14.80%


I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.