US Bond Yields Made in Germany

Another round of central bank easing is underway. So why are bond yields rising?

The 10-year US Treasury bond yield rose from a recent low of 1.47% on 9/4 to 1.72% on Tuesday (Fig. 1). The record low was 1.37%, hit on 7/8/16 just after the Brits voted to leave the European Union (EU). The risks of a no-deal Brexit have eased in recent days, though it still could happen next month. A hard Brexit could cause the bond yield to retest its recent low.

In any event, the main reason that the US bond yield has moved higher in recent days has more to do with Germany than the UK. The 10-year German government bond yield has risen from a recent record low of -0.71% on 8/30 to -0.54% Tuesday. Reuter’s reported: “Germany’s 30-year government bond yield briefly rose into positive territory on Tuesday for the first time in over a month, lifted by expectations for fiscal stimulus and caution over the scale of stimulus the European Central Bank might deliver this week.”

During a parliamentary budget debate on Tuesday, Germany’s Finance Minister Olaf Scholz said that Germany can counter a possible recession with a big stimulus package. On Monday, Reuters reported that Germany was considering creating a “shadow budget” to boost public investment above and beyond limits set by its national debt rules, sparking a bond sell-off.

European Central Bank (ECB) President Mario Draghi has been lobbying for fiscal policy to turn more stimulative to support the ECB’s ultra-easy monetary policies. Germany has resisted doing so and even questioned whether the ECB’s asset purchase program could legally buy sovereign bonds. Germany’s fiscal and monetary conservatives might be starting to waver as a result of Germany’s intensifying manufacturing recession, with factory orders and production down 5.6% and 4.8% y/y through July (Fig. 2).

Last year, when there was widespread bearishness in the bond market, with some predicting that the US yield would rise from 3% to 4%-5%, I observed that the US bond yield might be “tethered” to the comparable German and Japanese yields, which were barely above zero. This year, both have dropped solidly below zero.

During the Q&A portion of his 7/25 press conference, Draghi pleaded for more fiscal stimulus, especially from Germany:

“What’s hitting the manufacturing sector in Germany and [elsewhere in Europe is] an idiosyncratic shock. Here what becomes really very important is fiscal policy. [T]he mildly expansionary fiscal policy is supporting activity in the euro area. But if there were to be a significant worsening in the Eurozone economy, it’s unquestionable that fiscal policy … becomes of the essence. … I started making this point way back in 2014 in a Jackson Hole speech: monetary policy has done a lot to support the euro area … but if we continue with this deteriorating outlook, fiscal policy will become of the essence.”

From FOMO to FONIR

I visited with our accounts in Atlanta and Chattanooga recently. They seemed relatively calm. Most of them believe that the US economy can continue to grow for the foreseeable future. So they aren’t freaking out about the recent inversion of the yield curve. However, they are somewhat anxious about the prospect of negative interest rates in the US, though they think it is a remote possibility. Consider the following:

(1) US bond yields stand out. We discussed in our meetings the expectation that the Bank of Japan (BOJ) is likely to keep its official policy interest rate at -0.10% for the foreseeable future, as it has since 1/29/16, while the Governing Council of the European Central Bank (ECB) is likely to lower its official deposit rate, currently -0.40%, deeper into negative territory at its 9/12 meeting (Fig. 1). The ECB is widely expected to resume quantitative easing at that meeting as well (Fig. 2).

Such expectations have driven the 10-year German government bond yield down to -0.70% on Monday from 0.24% at the start of this year. At 1.50% on Friday, the 10-year US Treasury bond yield is literally outstanding compared to the comparable yields available overseas: UK (0.34%), Japan (-0.27), Sweden (-0.34), France (-0.40), Germany (-0.70) (Fig. 3). The negative-interest-rate policies (NIRPs) of the ECB and BOJ are increasing the amount of negative-interest-rate bonds (NIRBs) around the world.

(2) Dividend & earnings yields stand out. The rationale for remaining bullish on US stocks seems to be shifting from TINA (there is no alternative) and FOMO (fear of missing out) to FONIR (fear of negative interest rates). These fears are inherently bullish for stocks and continue to overcome the bearish fear that an inverted yield curve is predicting an impending recession, i.e., FOIYC (fear of inverted yield curve).

A few of the accounts with whom I met recently noted that the 10-year US Treasury bond yield at 1.50% is below the S&P 500 dividend yield, at 1.90% during Q2-2019 (Fig. 4). That is one very good reason why they remain mostly fully invested in the stock market. I observed that the forward earnings yield of the S&P 500, at 6.06% during August, is even more outstanding compared to the bond yield (Fig. 5).

(3) Performance derby. The 119bps drop in the US bond yield since the beginning of the year certainly has benefited dividend-yielding stocks. The S&P 500 sectors that tend to have lots of dividend-paying companies have outperformed those that tend to have fewer of them: Information Technology (28.0% ytd), Real Estate (26.0), Consumer Discretionary (20.3), Communication Services (20.0), Consumer Staples (19.0), Utilities (17.6), Industrials (17.4), S&P 500 (16.7), Financials (12.6), Materials (11.9), Health Care (4.6), and Energy (-0.5) (Fig. 6).

FONIR should continue to benefit dividend-yielding stocks. Their high valuation multiples reflect investors’ willingness to pay up for these stocks, as evidenced by the relatively high forward P/Es of the S&P 500 sectors with lots of dividend payers: Real Estate (44.0), Consumer Discretionary (21.2), Information Technology (19.6), Consumer Staples (19.6), Utilities (19.4), Communication Services (17.4), Materials (16.9), S&P 500 (16.8), Industrials (15.4), Health Care (14.8), Energy (14.7), and Financials (11.4) (Fig. 7).

(4) Real yields. During July, the US bond yield averaged 2.05%, while the CPI inflation rate was 1.80%. So the inflation-adjusted bond yield was close to zero, at 0.25% (Fig. 8). During August, the bond yield fell below the inflation rate. In other words, in real terms, bond yields are entering negative territory. Meanwhile, the real earnings yield of the S&P 500, using reported earnings, remained solidly in positive territory during Q2-2019, at 3.02% (Fig. 9). The real forward earnings yield of the S&P 500 was 4.03% during July (Fig. 10).

Trump's Game of Chicken

President Donald Trump seems to be playing simultaneous games of chicken with Fed Chair Jerome Powell and Chinese President Xi Jinping. Last Friday, he raised tariffs again on US imports from China and ordered US companies to leave China. He also said that Fed Chair Jerome Powell is a greater enemy than Xi. Trump’s game plan is to create more uncertainty about trade, thus increasing the risks for US economic growth so that the Fed will have to respond with more interest-rate cuts. At the same time, he hopes that Xi will relent by agreeing to a trade deal that is good for the US economy.

Games of chicken are often reckless and dangerous, with dire consequences. The S&P 500 tumbled 2.6% on Friday. In the classic movie “Rebel Without a Cause” (1955), Jimmy (played by James Dean) agrees to a “chickie-run” to settle a dispute with Buzz, the leader of a local gang. Both race stolen cars toward the edge of a cliff. The first to jump out of his car is branded a “chicken.” Jimmy flings himself out an instant before the cars reach the edge of the cliff. Seconds into the race, Buzz discovers that his jacket is stuck on the door handle. So he goes over the cliff and dies.

The question for all of us is whether Trump is Jimmy or Buzz. Is Trump trumping Powell and Xi or is Trump trumping Trump?

Our 7/11 Morning Briefing was titled “Powell Gets Trumped!” I wrote: “President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy. In his congressional testimony yesterday on monetary policy, Powell mentioned the trade issue eight times in his prepared remarks.”

Sure enough, the Fed lowered the federal funds rate by 25bps on 7/31. However, that afternoon, Trump said that it wasn’t enough and that he wants more easing right away. Trump was quick to attack the Fed’s decision. He tweeted: “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world. … As usual, Powell let us down, but at least he is ending quantitative tightening, which shouldn’t have started in the first place—no inflation. We are winning anyway, but I am certainly not getting much help from the Federal Reserve!”

The very next day, Trump trumped Powell again by creating more uncertainty about trade when he said that the US will impose a 10% tariff on an additional $300 billion worth of Chinese imports next month. The new tariff comes on top of the 25% levy that Trump already has imposed on $250 billion worth of Chinese imports—so the US will be taxing nearly everything China sends to the US. Trump added that the tariffs could be raised to 25% or higher if the talks drag on further without any significant progress, but he allowed that alternatively they could be removed if a deal is struck.

Then on 8/14, stocks rebounded after the Trump administration de-escalated its trade war with China. The 10% tariff would be delayed until 12/15 on imports from China of cellphones, laptop computers, toys, and other items. No reason was given. Trump trumped Trump.

In our 8/7 Morning Briefing, I wrote: “What does Trump want? He wants to win another term on 11/3/20. What does Xi want? He wants Trump to lose. They both know that. Xi is president for life, so he figures he can easily outlast Trump, though having to deal with Trump through 2024 would be more challenging than through 2020. Trump must know that even if he gets a deal with China before the election, that won’t mean much if he loses. He seems to be talking up the scenario of a post-election deal, perhaps believing that timing will yield a better deal from the Chinese, assuming he wins a second term.”

I concluded in that commentary: “Trump must figure that he needs the Fed to lower interest rates while he waits for the Chinese to come around on trade, hoping to strike a deal after the elections.” Trump’s game is to trump Powell before he trumps Xi.

By the way, Bill Dudley is apoplectic about Trump's game of chicken. Dudley served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee from 2009 to 2018. He revealed his antipathy for the President in a 8/27 Bloomberg View op-ed titled “The Fed Shouldn’t Enable Donald Trump.”

He wants the Fed to fight fire with fire: “I understand and support Fed officials’ desire to remain apolitical. But Trump’s ongoing attacks on Powell and on the institution have made that untenable. Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks—including the risk of losing the next election.”

In other words, the Fed shouldn’t offset the uncertainties caused by Trump’s trade policies with lower interest rates, even if that leads to a recession. The Fed should refuse to meet its legal mandate to maintain full employment and price stability rather than enable Trump.

Dudley is essentially calling for the Fed to overthrow the President in the coming election: “There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”

I am almost speechless. Dudley may be calling on the Fed to join the resistance and to fight fire with fire, but that would be playing with fire for the Fed. Welcome to the New Abnormal, where everyone loses their minds! Trump has the amazing ability to make sane people go insane. (For more on this, Google search “Trump Derangement Syndrome.”)

Bonds In Neverland

The negative interest rate policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) have created a Neverland in the global fixed-income markets. An 8/18 Bloomberg story reported: “The world’s headlong dash to zero or negative interest rates just passed another milestone: Homebuyers in Denmark effectively are being paid to take out 10-year mortgages. Jyske Bank A/S, Denmark’s third-largest lender, announced in early August a mortgage rate of -0.5%, before fees. Nordea Bank Abp, meanwhile, is offering 30-year mortgages at annual interest of 0.5%, and 20-year loans at zero.”

A 7/29 story in The Washington Times reported: “The latest estimates are that approximately 30 percent of the global government bond issues are now trading in negative territory. Last week, Swiss 50-year borrowing costs fell below zero percent, which means that Switzerland’s entire government bond market now trades with negative yields. Earlier in the month, Denmark became the country to have its entire yield curve turn negative.”

During 2018, when the 10-year US Treasury bond yield was rising toward last year’s high of 3.24% on 11/8, there was much chatter about its going to 4%-5%. For example, on 8/4 at the Aspen Institute's 25th Annual Summer Celebration Gala, JP Morgan Chase Chief Jamie Dimon warned that the 10-year US Treasury bond yield could go much higher: “I think rates should be 4% today. You better be prepared to deal with rates 5% or higher—it's a higher probability than most people think.”

At the time, the bears worried about mounting federal deficits, resulting from the tax cuts at the beginning of the year, at the same time that the Fed was on track for more QT. In addition, there was mounting evidence that inflationary pressures were building, with some related to Trump’s tariffs.

In my 8/8/18 daily commentary, I wrote: “So why isn’t the US bond yield soaring? The bulls respond that trying to forecast the bond market using flow-of-funds supply-vs-demand analysis has never worked. It’s fairly obvious that US bond yields are tethered to comparable German and Japanese yields, which are near zero, and are likely to remain there given the stated policies of both the ECB and BOJ to keep their official rates near zero for the foreseeable future.”

The tether has gotten tighter since last year’s peak in the US bond yield on 11/8. Since then, the US bond yield has dropped 164bps to 1.60% on Monday, while the comparable German and Japanese yields are down 111bps to -0.65% and 36bps to -0.23%, respectively.

Now consider the following related developments in the US bond market:

(1) Tipping into negative territory. The 10-year TIPS yield dropped to zero on Monday, suggesting that the nominal yield reflects only inflation expectations with no real yield. The TIPS yield could be about to turn negative, as it did in 2012.

(2) Real rates and productivity. Why should the real bond yield be negative or even zero? The most widely accepted notion is that the real bond yield should be related to the growth rate in productivity, which is the economy’s real return, arguably. The correlation between the two—using averages over five-year time periods—is not compelling, though. In any event, productivity growth has been turning up over the past few years. Productivity has been growing faster in the US than in the other G7 economies.

(3) Demography is destiny. The geriatric trend in global demographic profiles does support a case for negative nominal and real interest rates if the trend leads to a combination of slow growth and deflation. That’s if deflation reduces the value of assets purchased today with debt. Negative interest rates on that debt might reflect the voluntary self-extinction of the human race attributable to the collapse of fertility rates around the world. Dwindling populations, particularly of younger people, will put downward pressure on real asset prices, because there will be less demand for the goods and services they provide in the future.

Yield Curve Inverts: Head for the Hills?

The stock market tanked on Wednesday, August 14 because the yield spread between the 10-year US Treasury bond and the 2-year Treasury note turned negative. Such an inversion of the yield curve is widely viewed as a reliable leading indicator of economic recessions. In fact, it is one of the 10 components of the Index of Leading Economic Indicators. But so is the S&P 500, which remains close to its recent high but would fall sharply if stock investors become convinced that a recession is imminent.

Not only did the stock market react badly to the latest yield-curve inversion, but so did President Donald Trump, who tweeted: "CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back."

An inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn't as accurate a predictor of economic downturns as widely believed. It can be misleading.

In our recently published study "The Yield Curve: What Is It Really Predicting?," we concluded that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So investors on the lookout for a recession should instead pay attention to credit availability. Recession-watchers should keep an eye on bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch. In our study, we observed:

“One widely held view is that banks stop lending when the rates they pay in the money markets on their deposits and their borrowings exceed the rates they charge on the loans they make to businesses and households. So an inverted yield curve heralds a credit crunch, which inevitably causes a recession. …The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984.”

Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.

Our study includes a “Primer on the Yield Curve,” based on “Dr. Ed’s” book Predicting the Markets (2018). It also includes several useful charts for gleaning more insights into the relationships of the yield curve to the economy and to financial markets.