Sliding bond yields spur bubble talk
Sliding bond yields spur bubble talk
By Michael Mackenzie
Published: December 2 2008 19:03 | Last updated: December 2 2008 19:03
In the past decade, asset bubbles have emerged and subsequently popped in technology stocks, real estate, credit and commodities.
Now, with the yield on the 10-year US Treasury note falling below 2.70 per cent to its lowest level since 1955, traders are saying it is easy to think that government bonds no longer reflect long-term fundamentals. The yield has fallen by more than 100 basis points in a month.
“It’s a bubble as over the long term these low yields are unsustainable,” says Dominic Konstam, head of interest rate strategy at Credit Suisse.
“At some point the Fed will exit its liquidity programmes and there is no way these interest rates are sustainable.”
Government bond yields in the US, UK and eurozone have fallen sharply in recent weeks as investors have grown increasingly fearful of a prolonged period of weak economic growth accompanied by falling inflation and possibly deflation.
These forces have offset the growing cost of planned government stimulus and bank recapitalisation packages, which will dramatically increase the size of bond markets in the coming year.
‘We are starting to get to levels that are very low and could hurt investors’
Rick Klingman, BNP Paribas
“People who lost money in stocks are now lending money to the US government for 30 years at a yield of 3.30 per cent,” says Rick Klingman, managing director at BNP Paribas.
“We are starting to get to levels [in yields] that are very low and could ultimately hurt investors.”
So far this year, US Treasuries have generated a total return of 11.3 per cent according to Barclays Capital. This makes it the best year for Treasuries since 2002 when the return was 11.8 per cent.
One long-standing bond bull is David Rosenberg, chief North American economist at Merrill Lynch.
While the market “has moved into overvalued territory”, he says, “this overvalued condition is likely to persist as the Fed, households and institutional investors emerge as large-scale buyers, even as foreign central banks pull back”.
European markets follow Treasuries amid deteriorating global conditions
Since the credit crisis blew up in August last year, European bonds have often taken their cue from US Treasuries, the biggest and most liquid market in the world, writes David Oakley.
This has been best illustrated by German Bunds, Europe’s deepest market, which have followed the sharp fall in Treasury yields – but at a much slower pace.
US benchmark 10-year yields have fallen by 100 basis points more than Bunds since the summer of 2007.
This is because the US has benefited most from risk aversion as it is the ultimate safe haven.
However, it is also partly explained by the crisis at first hitting the US harder, prompting a series of aggressive rate cuts from September last year by the Federal Reserve.
The European Central Bank, by contrast, has moved much more gradually and even increased rates as recently as July.
Meyrick Chapman, fixed income strategist at UBS, says: “The economic impact was delayed in Europe. There were only really bad data in the past two or three months. Even in September, the Germans were calling the crisis an Anglo-Saxon one.”
In the past three weeks, Treasuries have begun decisively to outperform Bunds. Since November 15, 10-year Treasury yields have outperformed Bunds by 60bp. The US 10-year bond now trades about 40bp below equivalent German paper. Before the credit crisis, Bunds often traded below Treasuries.
Some analysts attribute Treasury outperformance to the actions of the Fed, saying it has shown greater imagination in attempting to stimulate the economy and bail-out US banks.
There is also a sense that Treasuries will benefit from the announcement by Ben Bernanke, the Fed chairman, on Monday that the central bank might buy US government bonds.
Sean Shepley, fixed income strategist at Credit Suisse, says: “The single most important reason for US bonds’ recent outperformance has been the direct intervention by the US authorities in the mortgage market and the expectation that they may do the same in the Treasury market.”
Other analysts say Treasuries are simply benefiting from safe haven flows.
The hunt for safety and liquidity has also seen Germany outperform other European markets, such as UK gilts, and particularly those considered risky on the eurozone periphery, such as Italian bonds. Since July, 10-year yield spreads between Germany and Italy have widened from 50bp to 124bp.
Ben Bernanke, chairman of the Federal Reserve, gave a further boost to the bond boom on Monday when he said that the central bank could buy substantial amounts of long-term Treasuries. The Fed’s move last week to buy up to $500bn in mortgages, had already boosted Treasuries, which are widely used in hedging mortgage rate risk.
Such policy actions are designed to counter deflation, a situation when consumer prices generally decline. The shadow of deflation has hung over Japan, for much of the last 15 years and the yield on 10-year paper there stands below 1.4 per cent.
Expectations of inflation largely determine the value of long-term bonds as over time their fixed returns are eroded by rising consumer prices.
In recent weeks, the relative prices of fixed-income and inflation-linked bonds imply the US will have deflation for the next five years – a situation for which the only precedent is the Depression years of the early 1930s.
“The answer to the question as to whether bonds are a bubble depends on your outlook for inflation over the long term,” says Colin Lundgren, senior portfolio manager at RiverSource Investments.
In the US, fear of deflation last resonated in 2003 when the yield on the 10-year note touched a low of 3.07 per cent. It quickly turned up to over 4.60 per cent as deflation proved to be a false alarm.
Unlike 2003, the economy is still slowing down and economists expect a sharp contraction extending into 2009. That backdrop could keep Treasury yields very low for some time.
It could also keep investors from buying riskier corporate debt, where yields have in recent weeks risen to the widest spread above government bonds ever recorded.
“Good times for Treasury investors don’t last forever,” says Mr Lundgren, who warns that pricing out inflation risk is bold given the swings in sentiment over the past decade.
As recently as June, the bond market was pricing in a series of rate hikes by the end of the year due to worries about inflation, and the yield on the 10-year note was around 4.25 per cent.
The prospect of investors spurning Treasuries and buying riskier bonds will only emerge once the economy show signs of stabilising and corporate defaults are contained.
Meanwhile, equities look cheap in theory as the S&P 500 dividend yield is above the 10-year note yield for the first time since 1958.
That comparison is discounted by some analysts.
“Despite extremes of valuations we still retain our strong bias towards government bonds and think yields will plunge further over the next six months,” says Albert Edwards, strategist at Société Générale.
“It is worth reflecting that the Japanese dividend is now twice the 10-year bond yield and that the equity market still keeps falling lower and lower.”
The notion that the US could see a period of sustained deflation like Japan is not shared by all observers.
Unlike Japan, the US has accumulated hefty debts with foreign investors who own just over half of the $4,700bn in outstanding Treasuries.
For a country in this position, some inflation, which reduces the cost of the debt, is arguably desirable. Moreover, these investors are sitting on solid gains as yields have fallen so far and they could well need additional funds for fiscally priming their domestic economies.
“A debtor nation can’t sustain deflation,” says Mr Konstam.
Against the backdrop of the Fed buying mortgages and possibly Treasuries, there is a risk that the dollar slides sharply as inflation returns, heralding a move out of US assets by foreign investors, he warns.
Copyright The Financial Times Limited 2008
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