June 5, 2019 / 2:02 PM / 6 months ago

Breakingviews - Hadas: Shaky assumption underpins debt demand

LONDON (Reuters Breakingviews) - Long-term government bonds are growing more expensive. But they offer investors a reasonable deal, under one condition: that history keeps repeating itself.

Traders watch the news conference held by European Central Bank (ECB) President Mario Draghi, during a trading session at the Frankfurt stock exchange January 22, 2015. REUTERS/Ralph Orlowski

Demand for high-grade sovereign debt has pushed the yield on benchmark 10-year U.S. Treasuries to 2.1% from 3.3% in November 2018 despite a deteriorating budget deficit outlook. And comparable debt issued by Germany, which ran a budget surplus last year, now yields -0.2% compared with 0.47% seven months ago.

The reason investors want to buy bonds with yields below zero is that they are worried the global economy is slowing and will generate less inflation. The slowdown seem to be here. For example, the reading on Monday’s IHS Markit’s U.S. Purchasing Managers’ Index fell to its lowest since 2009. Also, weakening activity will force central banks to keep interest rates lower for even longer than anticipated. Under such circumstances, it makes sense to buy longer-dated securities, before their yields fall even further.

The relative resilience of equity markets might appear to run counter to debt market gloom. The leading U.S. and German stock indexes are down a relatively trifling 3% and 4% in the past seven months. But shares are often boosted by low policy interest rates and companies that are included in these blue-chip indexes might outperform their domestic economies.

More puzzling is the idea that top-quality bonds could be a good investment at current yields. Bond investors generally want a return that is close to the rate at which nominal GDP is growing, that is real growth plus inflation. Over the last 10 years, U.S. real GDP increased at a compounded rate of 2.2%. If the next decade is like the last, investors are settling for poor returns, since inflation averaged 1.6% over the past decade. That seems like an irrational investment strategy.

But investors may have a different interpretation of duller economic prospects – it reduces the chance that the nearly four-decade trend of declining inflation rates is coming to an end. Since March 1980, when the U.S. inflation rate reached a high of 14.6%, each cyclical inflation peak and each cyclical trough has been lower than the last. For example, the July 2017 peak of 2.9% was almost a percentage point below the August 2011 high point. The most recent reading was 2%.

This time could have been different. A rekindling of at least some modest U.S. inflationary flames was possible following several years of reasonable GDP growth, record low unemployment rates, and increasing corporate profitability. But the economy is losing momentum. If the average inflation rate falls by yet another percentage point over the next economic cycle, even a 2.2% nominal return will look respectable.

The negative yields in Germany are harder to swallow, even if the European Central Bank proves a less willing or able disinflation-fighter than the U.S. Federal Reserve. To keep up with even low nominal GDP growth, the average 1.3% euro zone inflation rate of the last decade would have to slide into persistent annual price deflation. That would be extraordinary in modern times. Over the last decade, the average inflation rate in Japan, which is often called deflationary, has been 0.3%. Still, if the ECB keeps overnight interest rates far below zero for much of the decade, long-term debt may outperform short-term.

There are, however, two potential novelties to watch out for when trying to guess whether disinflation will persist. The first is fiscal policy. Even very negative policy interest rates might not do much to stimulate the economy, prodding governments into large radically inflationary policies. Big increases in minimum wage levels or in public sector pay would be an obvious technique. Alternatively, fiscal deficits could be increased so much that prices start to rise throughout the economy.

Uncontrolled trade wars could be the second new, potentially inflationary development. U.S. President Donald Trump’s erratic trade policies might lead to shorter supply chains and force companies to make expensive investments in local factories and technologies. If so, costs and the prices paid by consumers would rise. That would reverse one of the trends which is often cited as a structural cause of downward pressure on both inflation and wages.

Neither persistent negative rates nor an unravelling of globalisation is inevitable. And neither might reverse longstanding disinflationary trends. In that case, investors may be clever to buy bonds now, just as they have been for nearly half a century. But when financial assets are priced for perfection, the discovery of even the slightest blemish can prove costly.

Breakingviews

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