Depressed Yields

After a painful week for bondholders, with the U.S. 10-year bond down 20%, and the 30-year bond down 14%, investors are wondering if yields will stabilize or continue higher. The consensus view says that increased policy uncertainty and expectations for higher deficit spending by the incoming Trump administration will be inflationary and lead to higher rates. While we know this has played a major role in the yield run-up this week, it is also important to remember that lower global yields stemming from slow overseas growth, coupled with the negative interest rate programs (NIRP) from central banks in Japan and Europe, are likely to continue to put downward pressure on U.S. yields moving forward.

NIRPs in Europe and Japan were intended to provide banks with the incentive to make loans, but they have also greatly depressed yields overseas, which can easily be seen by comparing the Spanish 10-year bond with the U.S. 10-year. Spain’s credit rating is Baa2 according to Moody’s, well below the U.S. bond’s Aaa, the highest credit quality. Investors, however, can buy the higher quality, lower risk U.S. bond at a 2.22% yield, versus 1.54% for the Spanish bond. The normal assumption is that lower quality bonds must trade at a higher yield to compensate investors for the greater risk.

German 10-year bonds are yielding just 0.29%, France’s are yielding 0.74% and Italy’s stand at 2.04%. With the exception of Germany, these bonds are lower quality than U.S. bonds. We are not arguing that the 2.22% U.S. yield can’t go higher, quite the contrary, but that global bond yields are too low and should eventually increase. However, this may take some time as global central banks continue to provide liquidity over the near term, as the European Central Bank (ECB) isn’t scheduled to reduce its quantitative easing program until March 2017.

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The total amount of negative yielding debt worldwide peaked in June at about $12.2 trillion, but has fallen to $8.7 trillion following the U.S. election (according to Bloomberg data), a large decline but still enough to put downward pressure on global yields. As we have recently seen, it’s possible for U.S. yields to move higher, but the still large amount of negative yielding debt worldwide may continue to keep U.S. yields lower than they would otherwise be in the near term.

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