The only way is down (or so it seems)

Author: Hans van Zwol, Senior Portfolio Manager, Global Fixed Income at NN Investment Partners

Hans van Zwol

The yield on 10-year German government bonds recently dropped into negative territory, reaching a new all-time low of -0.2% on 6 July. Downward pressure on safe government bond yields seems to be a global phenomenon; 10-year US and Japanese government bond yields also reached new lows. The current level of bond yields is eye-catching, but the relentless fall in yields over the last few years is also worthy of some comments.

Lower rates

Since the financial crisis of 2008 we have witnessed capital markets in which, with the exception of a few short-lived corrections, safe government bond yields only went down. The remarkable feature of this long slide down has been that all traditional relationships seem to have disappeared. It is normal that safe government bond yields fall in times of weak economic data, falling inflation, loose monetary policy, falling equity markets, rising credit spreads, et cetera.

However, they continued falling in times of strong economic data, rising inflation, equity markets making new highs and rapidly falling credit spreads. Last Friday was a case in point. The US employment numbers were much stronger than expected, but 10-year US Treasury yields fell further nonetheless. What is going on?

Risk averse

Many reasons have been put forward for the trend toward ever-lower interest rates: high excess savings caused by an aging population, investors in the grip of ‘dread risk’ (i.e. highly risk averse) since 2008, disappointing economic growth and low inflation in the developed countries, a slowing Chinese economy, extremely loose monetary policies of the major central banks, the big drop in oil prices, asset-liability matching by pension funds and insurance companies, et cetera. Recently, the falling yield trend seems to have intensified.

This is, in our view, best described as a ‘final capitulation’. It seems as if market participants have given up on the idea that they will ever witness rising yields in their lifetime. If one believes that the current low growth, low inflation and very low yield environment is an enduring one, it makes sense to continue investing in safe government bonds.

We view the current situation as a ‘tug of war’ between, on the one hand, the above-mentioned strong demand for safe government bonds and, on the other, rather extreme valuations. So far, the ‘demand side’ has had the upper hand but at some point one would expect the ‘value side’ to start pulling its weight. There has to be a limit to how negative yields can go and, at some point, we would expect economic growth and inflation to start moving up again.

This assumes that the world economy will avoid a deep recession in the foreseeable future. From a long-term perspective we feel that safe government bond yields are too low, but in the meantime they might well continue to fall further.