What Is Going On In The Bond Markets?

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by: John M. Mason
Summary

About two weeks ago, bond yields dropped and the first feeling was that investors' expectations about economic growth were slowing.

Looking at the data a little closer and including world changes in interest rates at this time, one could make the argument that political uncertainties were impacting risk averse funds.

We know that a lot of very nervous money exists in the world and that rates in the US and Germany have not fully recovered since the end of 2016.

As I stated in December 2019, keep your eyes on the bond markets in 2019. And, I believe, watching the bond markets has given us the most interesting insights into the economic situation and the attitude of investors available.

The latest bounce in the bond markets came in the last half of March.

In the US markets, the 10-year Treasury note closed to yield 2.62 percent on March 19.

A week later, this security yielded less than 2.40 percent.

Breaking this nominal yield up into its two hypothetical components, the expected real rate of interest and the expected rate of inflation, we see that both components of the nominal yield dropped by slightly more than 10 basis points.

One can interpret this drop in both the expected real rate of interest and expected real inflation as a concern over slowing economic growth in the United States and a reduction in the pressure on price increases.

The interesting thing about this drop, however, is that world markets were experiencing the same thing.

Concentrating upon other securities around the world that are considered to be “risk free” or close to being “risk free”, we see that the yield on the 10-year German bund dropped from around a “positive” 10 basis points to a “negative” 7 basis points.

This is the first time that the yield on the 10-year German bund has become negative since October 6, 2016.

It appears as if the forces impacting the yield on US Treasury notes are also impacting the yield on German bunds, the two securities considered most risk-free in the world.

And, these two instruments are also considered to be two “safest havens” for “risk averse” monies in the world.

So, this fact raises another question.

Maybe the issue in the bond market is not one of just slower economic growth, but a feeling on the part of investors that uncertainty is growing in the world, making it prudent for some of the more risk averse investors to protect their assets in these safe havens.

Remember, that for several years, the yield on the 10-year German bunds and the yield on the 10-year US Treasury Inflation Protected securities (TIPs) remained in negative territory or in just positive territory until the latter part of 2016.

This was the time period when the world was experiencing so much uncertainty that lots and lots of risk averse money moved to this instruments and remained there for an extended period of time.

It has been my belief that not all of these risk averse funds have left these safe havens, even over the past two years or so. This is has been my explanation for the continued low yields on the TIPs and the German bunds during this time. Interest rates in these securities just did not achieve levels I thought were appropriate for the times and economic conditions.

Now, is it possible that the uncertainties in the world have reached such levels that we are seeing some more risk averse funds moving back into the “safe havens”?

There certainly seems to be enough uncertainty around.

Just take the mess surrounding Brexit. No one has any idea of where this situation is going. The original exit date has passed, March 29, 2019, but no one has the foggiest idea of what the near-term outcome might be, let alone what the ultimate outcome might be.

Well, that’s gone and there is little or no consensus of what might actually turn out. And, I believe that more and more people are beginning to understand the possible costs of a Brexit, even if some kind of a plan can be “taped” together at this late date.

Then there is the world trade situation. This includes the tariff discussion between China and the United States. But, it also includes other important issues, with many positions on trade being determined about one is for a more “nationalistic” economic policy or whether one is more into globalization.

But, there are other areas of concern such as the division occurring in the European Union and the efforts China is making into this area. There is the unrest in the Middle East, and so on.

Economic growth is slowing, but there is a growing realization that governments can no longer focus upon just “national” situations. The world is so connected now that central banks cannot just think about their own country and their own banking and financial markets when building up their monetary policy.

One bit of evidence here is the recent behavior of the US dollar. In the past year, the value of the dollar grew stronger as economic growth in the US was relatively strong, while that of Europe, for example, seemed to be dropping off.

The European Central Bank was ending its quantitative easing program at the end of 2018, and was expected to come into 2019 looking to raise its policy rate of interest.

The ECB, because of weak European economies, backed off from these increases.

The value of the US dollar got stronger against the Euro.

At its current level, the value of the US dollar has not been stronger against the Euro since the second quarter of 2017, right after President Trump began to “talk down” the dollar’s value.

The Federal Reserve has had to revise its plan for raising its policy interest rate in 2019, going from a possible three increases to only one… or, maybe none.

The Federal Reserve cannot just act on what is happening in the United States and what is best for America. At least for the time being, those days are over. So, where will monetary policy go?

My suggestion is to continue to keep an eye on the bond markets. We need to see whether or not the drop in bond yields in the US… and in Germany… really reflects a “new” flow of risk averse money into US and German ‘safe havens.” If this is the case, we have an entirely different setting than what was being experienced one month ago.

It is a setting where the uncertainties surrounding the political have reached new highs. It is a setting that can be highly volatile. It is a setting where the littlest spark might set off some kind of reaction, somewhere. Be careful!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.