Why Global Bond Yields Are Tumbling
Market pundits appear to be mostly dumbfounded as global bond yields continue to set record lows. For some examples; the 10 year German bund fell below 1%., the Italian 10 year note has dropped below 2.60%, Spanish bonds fell to 2.40 % and Japan is offering a shocking one half of one percent to borrow funds for ten years. Even Greece, whose bonds were on ECB life support just two years ago, has a 10 year note yielding below 6%. Worldwide bond yields are at all-time lows, leaving market commentators scrambling to come up with a creative array of explanations for this phenomenon. Tensions in Ukraine and escalating violence in the Middle East are some favorites. But at least in Europe and Japan, most are willing to attribute record-low bond yields to the real cause…that is no growth and deflation.
Curiously, here in the United States--despite bonds yields heading towards 52 weeks lows around 2.31%--those perpetually-bullish market strategists are extremely optimistic about growth in the second half. Just as they have been each year since the Great Recession ended in 2009.
Few commentators in the U.S. are willing to admit the truth that plunging bond yields are signaling the same thing here that they are in the rest of the globe, which is the inability of massive central bank money printing to engender real growth. These pundits have a myriad of other excuses to explain our low borrowing costs. But my favorite red herring is to completely lay the cause for our plunging yields on the low yields that exist in Europe and Japan. They claim it is the yield spread alone that is causing a monetary deluge into U.S. debt.
It is true the benchmark U.S. yield has been running more than 1.30 percentage points above the yield on 10-year German Bunds since the beginning of July. This premium is the biggest since June 1999, which was before the euro was introduced. Leaving many to summarily conclude that our yields must fall commensurately to that of Japan and Europe; despite their contention that the U.S. growth and inflation rates will be drastically different than that of those same countries.
But falling yields in the US are not solely due to an arbitrage between Treasuries and European/Japanese debt. To the contrary, it is because the fundamentals of low growth and cyclical deflation are the same in both countries. If the U.S. had differing fundamentals, like rapidly-rising inflation, then the yield spread would be rising instead of narrowing. That’s because foreign investors would need to be compensated for the increasing differential in real interest rates (much lower in the U.S. than in Europe). Therefore, this condition of falling real rates in the U.S. would cause the Euro to rise vis-à-vis the dollar and erode all incentives to own Treasuries near the same yield as European debt.
The truth is, the investors who make up the bond market are smarter than most who comment on it. They understand, bond prices are a result of Credit, Currency and Inflation risks. Since the credit risks of Europe and the U.S. are fairly commensurate, we have to assume a worldwide decline in yield reflects the market’s perception of inflation risk, or lack thereof. This is because the U.S. is ending its biggest QE program to date ($1.7 trillion worth of Fed asset purchases), which will bring about a short-lived respite from the inflation experienced over the last few years.
In 2011, I said the world was heading into a new paradigm – central banks around the globe were walking their economies on a very thin tight rope between inflation and deflation. Onerous debt levels had reached the point where the central banks would be forced into a difficult decision; either massively monetize the nation’s debt or allow a deflationary depression to wipe out the economy.
In this environment, governments are compelled to seek a condition of perpetual inflation in order to maintain the illusion of prosperity and solvency. However, once the central bank shuts off the money spigot, deflation then returns with a vengeance. As a result of winding down the massive money printing from the Fed, we are now seeing the very early signs of deflation. Yet, the usual talking heads are too busy cheering from the sideline to watch the game. And they see every deflationary signal the market is throwing them as another reason to get their pompoms out.
Falling commodity prices (down 8% on the CRB Index since June) are great for consumers and businesses in the long term. A period of deflation would be greatly welcomed in the long term, inasmuch as it represents a needed healing process from the Fed-induced inflation. However, it is not conducive to rapid growth in the short run because this deflation will be the result of collapsing asset bubbles.
The facts are that Japanese GDP is falling sharply, European growth is nil, and U.S. GDP for the first half of 2014 is under 1%. For those who love to continually applaud every central bank intervention, the failure of our Fed to produce sustainable growth seems not to be an option. So every data point is spun to support the narrative of an economic recovery. Unwilling to admit the Fed’s massive monetary experiment may fail, they sit in perpetual denial about our true economic condition and spin an elaborate web of excuses.
What they fail to realize is that QE never created viable growth, it just inflated asset prices. Likewise, the winding down of QE will not manifest growth, it will just temporarily deflate those bubbles that represent the greatest distortion of asset prices in the history of global economics.
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