Worries about economic recession, subdued inflation and a flight to quality have led interest rates in the U.S. to plummet in recent weeks. The flight to safety has helped push 30-year U.S. Treasury yields below 2% for the first time ever.
Significantly, two-year yields moved above those of 10-year Treasuries — an inversion of the yield curve that has often been a signal of approaching recession.
The question now being asked is: Can interest rates in the U.S. go negative, as they have in Japan, Germany and some other countries in Europe? The probability seems higher than ever before and cannot be entirely ruled out. However, many of our portfolio managers and economists don’t see it happening in the near term.
Even if they don’t turn negative, interest rates in the U.S. are likely to remain quite low, anchored by global demand for a positive yielding safe haven asset and U.S. Federal Reserve policy that remains highly accommodative.
1. Will bond yields in the U.S. turn negative?
Negative yields have been a feature of bond markets in Japan and the eurozone for years. As of early August, for example, 100% of German government bonds (bunds) had negative yields.
Despite the recent tumble in Treasury yields, “it seems unlikely that negative yields will come to the U.S. in the near term, given my outlook for modest economic growth,” says portfolio manager Pramod Atlurifor. “That said, if the four-decade downward trend in rates remains intact, ‘the zero bound’ could eventually be crossed.”
“Negative policy rates are, in my view, a remote possibility for the U.S. over the next few years,” says Tim Ng, a fixed income investment analyst at Capital Group. “I think the Fed’s playbook is more likely to follow what was done in the financial crisis: progressively cut rates to zero if needed and use forward guidance as a tool. The Fed could also buy bonds, as we saw with their quantitative easing efforts.”
Nevertheless, policymakers are keeping a close eye, and central bankers will likely discuss all options for this scenario at their annual gathering in Jackson Hole on August 22–24. The event should shed more light on the Fed’s current views on negative bond yields and, indeed, policy rates.
The topic has taken center stage once more, with the total amount of subzero bonds in the developed world hitting a record high in August of more than US$15.4 trillion. This figure easily beats the previous peak of US$12 trillion in 2016. Today, a little over a quarter of investment-grade bonds in developed global markets now offer a negative yield.
Negative yields essentially mean that investors are paying the issuer to hold their money. That generally happens during times of economic uncertainty, when buyers rush to snap up investments viewed as safe.
Negative yielding debt used to be contained to short-term investments — think two years or less — but recently the phenomenon has spilled over into longer dated five- and 10-year notes more significantly than in the past. Bonds backing the eurozone’s go-to safe haven, Germany, are broadly in negative territory with the 30-year bund yield negative for the first time.
2. If not negative, will U.S. rates remain extremely low?
Even though the financial professionals featured in this article don’t expect them to turn negative, U.S. interest rates are likely to remain low for several reasons:
- There is global demand for positive yielding high-quality bonds.
Despite trade tensions, rising U.S. government debt and recession worries, Treasuries continue to be viewed as a safe-haven asset — especially in times of uncertainty. This has underpinned global demand for the securities across all maturities. They are also relatively attractive, compared to the negative yields offered by Germany and Japan, for example, assuming an investor is comfortable with buying on an unhedged basis.
- The Fed is maintaining a highly accommodative stance.
Weaker global growth has encouraged the Fed to maintain a highly accommodative stance, even though U.S. economic growth remains decent and the labour market is strong.
While the core U.S. Consumer Price Index (CPI) has moved above 2%, the core Personal Consumption Expenditures Price Index (PCE) at 1.6% has remained well below the Fed’s inflation target, giving the central bank flexibility to further ease monetary policy. Inflation expectations have also remained muted. Markets have been pricing in five more rate cuts by the Fed by the end of 2020 following the 25-basis-point cut in July to put the Federal funds rate in a range from 2.00% to 2.25%.
Inflationary pressures have been low in much of the developed world. The slowdown in China, which has been one of the biggest consumers of industrial commodities, has also helped keep a lid on inflation.
Structural reasons may also help explain the lack of inflation. Labour costs have been contained as many industries turn to automation or make use of cheaper labour from elsewhere. Demographics are another likely cause.
”Global population trends point toward a near-term future where growth remains low in the U.S. and many other places,” says Anne Vandenabeele, an economist at Capital Group. “These developments, in combination with cheaper and more powerful technology, could also continue to depress inflation and yields globally.”
So, as populations age and expand more slowly, cheaper and better technology (around automation, for example) reduces the need for capital investments that can help the economy grow. Rather than undertake capital expenditure, many firms have instead funneled their cash into M&A, buybacks and financial assets more broadly, which has also helped push bond yields lower. The appeal of safe bonds will continue as the world grapples with weak regional economic activity. Meanwhile, global economic pressures tied to the well-trodden themes around the slowing population growth, an aging workforce and technological innovation aren’t going anywhere. The low-yield environment looks to be with us for quite some time.
- We are in the late stage of a global economic cycle.
China is experiencing an economic slowdown as the trade war with the U.S. slowed its second-quarter GDP to 6.2% from the prior quarter’s figure of 6.4%, and 6.6% in 2018. Many other developed economies are slowing. Germany reported a contraction, with GDP declining 0.1% in the second quarter on an annualized basis. Elsewhere, the fallout from Brexit has weighed on the UK’s economy, which most recently reported that GDP contracted 0.2% for the three months ended June.
3. Does the inverted yield curve signal a recession?
After more than a decade, a closely watched portion of the U.S. Treasury yield curve has inverted. In August, 10-year Treasury yields moved below two-year yields for the first time since the start of the great financial crisis in 2007.
Alongside other market and economic signals, this particular type of yield curve inversion is regarded as a harbinger of recession.
How worried should investors be? An inverted yield curve is clearly a bearish development, because it indicates that many investors believe future growth prospects will be lower than nearer term growth. Furthermore, inversion has preceded every U.S. recession over the past 50 years.
And yet, history also shows that 10-year yields falling below two-year yields is no cause for immediate panic. There has often been quite a lag between inversion and the start of recession — 16 months on average.
Economic and market indicators offer a way to take the temperature of the U.S. economy. One or two negative readings could be meaningless. But when several key indicators start flashing red for a sustained period, the picture becomes clearer and far more significant. That time has yet to arrive.
Although some imbalances are developing, they don’t seem extreme enough to derail U.S. economic growth in the near term. The culprit that ultimately sinks the current expansion may one day be obvious: Escalating trade disputes, falling consumer and business confidence, or unsustainable debt levels can be major triggers.
Pramod Atluri is a fixed income portfolio manager at Capital Group. He holds an MBA from Harvard and a bachelor's in biological chemistry from the University of Chicago. Pramod is also a CFA charterholder.
Tim has 13 years of investment experience and has been with Capital Group for five years. He covers U.S. Treasuries, Treasury Inflation-Protected Securities and interest rate swaps. Prior to joining Capital, Tim worked at WCG Management LP, UBS Investment Bank and Barclays Capital. He holds a bachelor's in computer science from the University of Waterloo, Ontario.
Anne covers economic developments in the U.S. and Japan. She has 18 years of investment experience, all with Capital Group. She holds master's degrees in economics from Oxford and the University of Edinburgh.