Global Bonds Enter The Twilight Zone?
Japan’s government bonds surged, driving down yields from five to 40 years to record lows as the yen surged after the central bank kept policy unchanged, while the Federal Reserve cited Brexit risk as a reason for standing pat.Earlier this week, we saw German 10-year sovereign bond yields turn negative for first time. Everyone is saying nothing fundamental is going on and it's all due to the uncertainty surrounding the Brexit vote next week.
Government debt worldwide has rallied to its best start to any year in two decades as Brexit concerns intensify pessimism that the global economy will struggle to regain momentum. Germany’s 10-year sovereign yield fell below zero this week for the first time. The U.K.’s June 23 referendum on whether to leave the European Union was factored into the Fed’s decision to leave rates steady, Chair Janet Yellen said on Wednesday in Washington. The Fed also eased back on interest-rate increase expectations.
Yields on all benchmark sovereign securities in the world’s second-largest bond market fell to records Wednesday, extending a rally fueled by global haven flows and the Bank of Japan’s January decision to introduce negative interest rates on top of purchases of about 80 trillion yen ($771 billion) a year of government debt. The BOJ left policy unchanged at the end of a two-day meeting Thursday as most economists had predicted.
Japan’s 10-year yield fell to a record minus 0.21 percent, while the 20-year bond yield dropped to an all-time low of 0.095 percent. Yields on 30-year bonds declined to a record 0.15 percent and five-year yield declined to a record minus 0.305 percent. The 40-year yield hit an unprecedented 0.2 percent Thursday.
“The BOJ for many was expected to keep its easing options and not do anything today” ahead of the U.K. referendum and also to monitor effects of the negative rate policy, said Yasunari Ueno, the chief market economist at Mizuho Securities Co. in Tokyo. “The yen kept rising after the BOJ’s outcome. The yen rising past 105 has had a great impact. Japanese yields are under more pressure to fall from falling U.S. yields and the yen’s appreciation.”
Global government debt had gained 5.5 percent this year as of Wednesday, the most for any comparable period since 1995, according to Bank of America Corp. indexes. Japan’s sovereign bonds generated returns of 6.6 percent, the data show.
The yen rose to 103.61 per dollar, the strongest since August 2014.
“JGB yields are at levels where they should be peaking out, but given that the U.K. is the underlying driver, Japanese yields are unlikely to reverse course and rise just yet,” said Katsutoshi Inadome, senior bond strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo.
The Bank of England is now warning that Brexit poses global financial risk. Federal Reserve Chair Janet Yellen said next week’s referendum in the UK on whether to remain in the European Union was a factor in the US central bank’s decision to hold interest rates steady at its meeting Wednesday in Washington. But the Fed also cited labor market concerns in its decision to push back back its plans to raise its benchmark short-term interest rate.
So what is going on? Are global bonds entering the Twilight Zone? Is this the new negative normal and are ultra low yields here to stay? Are central banks losing control, repeating the same mistakes and losing the titanic battle over deflation? Will the deflation tsunami strike us in the years ahead and will bonds be the ultimate diversifier? Or is deflation dead as central banks resurrect global inflation and the Treasury rally will turn into a rout? Will the yen's surge trigger a crisis, especially another Asian financial crisis? Is a bearish George Soros right or are stocks going to melt up in a deflationary world?
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Readers of my blog know I'm obsessed over one thing and one thing only: deflation vs inflation. Everything else is inconsequential to me. You need to understand the big picture before you take any risk in these crazy markets.
And global bond markets are telling me very clearly that central banks are losing the battle over deflation. Have a look at the yield on the 10-year Treasury note this morning (click on image):
The yield touched a low of 1.52% this morning before moving back up. If this downtrend continues, the yield on the 10-year will slice below the 1.44% reached back on July 16, 2012.
But let's say Brexit doesn't happen next week and the next US jobs report shoots the lights out, exceeding all expectations. Then you will have a huge snap back in global bond yields and I can see the yield on the 10-year heading back up to 2%.
Right now, you've got all these CTAs and large hedge funds leveraging their long bond trades up the wazoo, exacerbating the downtrend in global bond yields.
Remember what I keep telling you, nothing goes up or down in a straight line. Sure, we can have Brexit next week, the yen can continue surging, hedge funds will continue unwinding the yen carry trade and risk assets around the world will get clobbered and yields will sink to new lows, even if they are in negative territory.
But I'm not convinced Brexit is a done deal. The Brits aren't stupid and when it comes down to it, they will vote with their wallets, just like Quebecers voted with their wallets in past referendums. At the end of the day, everyone thinks about their economic well-being. Period. I couldn't care less about polls when it comes down to voting day, I think Brits will stay the course.
However, Brexit is just one hurdle for the global economy. There are plenty of others and unless policymakers figure out a way to stimulate and sustain aggregate demand, deflation will rule the day and global bond yields will stay ultra low for a very long time.
Below, Richard Kelly, head of global strategy at TD Securities, says bond yields are falling due to fears about the EU referendum in the UK. No doubt, fears of Brexit are exacerbating these moves, but that might not be the only thing worrying the bond market.
According to Dennis Davitt, partner at Harvest Volatility Management and a noted options market veteran, US bond yields could soon go negative. Listen to his comments below, I agree with him.
Lastly, Jeffrey Gundlach, DoubleLine CEO, discusses the consequences of negative rates. He thinks central banks are "out of control" because they don't understand the consequences of their own policies. I hope he's wrong but I'm afraid he's right. Listen closely to his comments.
Welcome to the Twilight Zone and get used to it.