The Desperate Hunt for Yield
That chart is the first of Austria’s two century bonds. You know, lending money to the Republic of Austria at 2.1% for 100 years. No biggie. Everyone laughed. Would your grandchildren even see it mature? Tra-la-la.
Who’s laughing now? Spurred by its success, the Austrians issued a second century bond at 1.2% in June and traders didn’t even wait until the auction was over before they drove the yield down to 1.17%.
If you are buying government debt at 1.17% without any hope of seeing your principal returned from that government in your lifetime, you are not that interested in the interest. You think rates are going much lower, and the bond’s value will appreciate. Those investors who bought that first bond are up almost 90%.
The global hunt for yield is on. The last time that happened was 2007. You’ll never believe what happened next.
Term Premium is Gone
Normally, time is a risk. I’m pretty close to 100% confident that the US Treasury will be around to pay off my 1-month bill, but something less-than-100% confident the same will be true for a 30-year bond. So investors typically demand more interest for longer-term loans — there is greater uncertainty the farther you get from the present, so the risk is greater, and the rate has to compensate for that risk. This is known as “term premium.” You pay a premium as a borrower for longer terms.
But Treasuries do not just pay interest, they are also tradable and pretty liquid. So when investors are convinced that rates are going lower, they will pile into Treasuries and hope to reap the type of gains that the Austrian century bond holders got. This destroys risk premium, because investors zero in on the terms where they think rates will be the lowest in the future, and drive down the yields in those maturities. This is known as inversion.
Let’s look at this all on a chart:
So, let’s break down what we’re looking at. The blue line is the yield curve from the beginning of November, when much of this action began. Note how it slopes up, with an elbow at the 2-year maturity. In mid-cycle, we typically don’t even see that, so the curve was already undergoing flattening in November.
The green line is from last Friday, and the red from a month before. With a Fed cut of 27 bps off the effective Fed Funds rate in the interval, everything from the 1-year maturity out has fallen by more than that. The 10-year is down 58 bps, over twice the Fed cut.
The horizontal orange lines are for reference. Starting at the bottom, we see that buyers of the 2-7 year maturities are accepting an interest rate below inflation; their money will be worth less at expiration if inflation were to remain the same. On the long end, only the 10-year is above inflation, and only by 1 bp. Investors are anticipating inflation going lower.
The middle orange line is the current effective Fed Funds rate, the only rate the Fed actually sets, at 2.13% on Thursday overnight. This is the rate that banks charge each other to fill small holes in their overnight reserve requirements. As the shortest of all rates, overnight, this would be the lowest rate with normal term premia, but as you can see, the entire curve is well-inverted with Fed Funds, with none of the rates even within 25 bps. Bond traders are anticipating another 3-4 rate cuts in the next year, and more after that.
The top line is the highest money market rate I know of. While not FDIC insured and risk-free, it is a pretty safe bet, and the money is liquid overnight to a bank or brokerage account. Think of a buyer of the 5-year maturity at 1.42%, where we have seen the hottest demand in the past couple of weeks. She is giving up 1.15% of easy interest. She is not buying the bond for the interest, she thinks rates are going much lower.
What would cause investors to believe there are more coming Fed cuts, lower Treasury rates and lower inflation? A near-term recession.
The Yield Curve and Recession
This is why the yield curve is such a good predictor of recession. To be clear it is not the cause of recession, but rather an artifact of investor behavior in the periods leading up to recessions historically. It does have a huge effect on bank earnings, much of which are reliant on borrowing short and lending long. When short is above long, that doesn’t work so well.
So this is the backdrop to pre-market last Wednesday, when the 2-10 spread inverted for a moment. To my disappointment, CNBC did not have hats proclaiming the moment like they did with "S&P 3000,” but they did their best to sound the alarm all day despite the oversight by producers. The 2-10 has been a pretty reliable indicator in the past, with recessions beginning anywhere from 6-24 months after first inversion. But this cycle has been a little strange, in that the 2-year and 10-year maturities moved down in tandem for most of 2019 until the most recent Fed cut, after which the 10-year plunged. It has not been inverted since that quick hit, but it remains very low historically at 7 bps.
But the gold standard of yield curve recession models is the NY Fed’s, based around the 3-month to 10-year spread. It is flashing red right now.
The daily probability of recession in the year-out reached over 37% for a cycle high on Thursday, and the moving average stands at its high of 33%. This is very high historically, with only one false positive above this level back in the 1960s.
According to bond traders, we are getting very close to a recession. Fun fact: sometimes bond traders are wrong. Who knew?
More Spreads: Corporate Debt
Another thing we see happen in rates as we get closer to recession is that corporate bond investors become suspicious of the lower rated companies, and begin driving the effective rates up on those bonds relative to the AAAs, or the best credit risks.
Starting with the BBBs, these are the lowest “investment grade” corporate bonds. But everyone knows that when recession rolls around, those BBBs sometimes turn out to not be very investable — so-called “Fallen Angel Syndrome,” where the BBBs get repriced as junk. So the spread between the AAAs and BBBs tends to rise quickly into recession.
Zooming in on the period since November:
As you can see, after a risk-off period following the December meltdown of confidence, the spread has turned up sharply in August since the Fed cut and the subsequent reappearance of Tariff Man.
We see a similar historical pattern with the CCC-AAA spread. These are so-called “junk bonds.”
Here we see a similar pattern as the BBB-AAA spread, except the risk-off mood began months earlier in May, and now we are back up to levels not seen since January. This one is moving quickly, like the Treasury spreads we discussed.
Finally, by comparing the AAA rate to the 10-year Treasury rate, we can see the implied risk of lending to the best corporate borrowers versus the nearly risk-free Treasury. After a long risk-off period, the spread has jumped rapidly in August.
The Rest of the World
You think we’re upside down? Check out the German yield curve:
The entire curve is negative-yielding and it’s happened in the past 6 months. Investors are paying the German government for the privilege of lending them money. Because they think rates are going even lower. This will continue to be a winning bet, until it isn’t.
As of August 14, the global supply of negative-yielding government debt was $16 trillion. That number seems to go up every day.
Soon that Austrian century bond may go negative.
Does Any of the Above Sound Sustainable to You?
There will be plenty of people who will tell you, “this time it’s different.”
Spoiler alert: it never is.
See you in September.
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.