Here’s what the bond markets are really telling us

Yields on leading government bonds continue to fall to record lows. Some investors are paying to hold them at a moment when stock markets are both volatile and weakening. There is existential fear abroad which few institutions will admit to, writes Victor Hill.

Interest-rate expectations

At the beginning of 2019 global markets expected that interest rates would trend upwards, led by the Federal Reserve. Before last Christmas its Chairman Jerome Powell described monetary contraction as being on autopilot. Eight months later the interest rate outlook has pivoted completely – markets now expect further interest rate cuts even though in some jurisdictions, most notably Japan and the eurozone, interest rates are already negative. This essential fact, combined with concerns about a global slowdown in growth and the impact of the US-China trade war, is having a highly distorting impact on bond markets.

As the expectation about imminent rate cuts has set in, so bond prices have edged upwards and thus bond yields have fallen further. In particular, the 10-year German Bund has benefited (or suffered, depending on your point of view) from a flight to quality, being the euro-denominated asset with the lowest perceived default risk. It is now yielding something like minus 66 basis points. In fact, the government debt of a slew of eurozone countries, including France, the Netherlands and Spain, is now carrying a negative yield. Meanwhile in the robust USA the yield on the 30-year Treasury bond dipped below 2 percent for the first time last week.

Strictly speaking, we are talking about the yield-to-maturity. So investors in Germany’s 10-year Bund would lose 0.66 percent of their initial investment every year if they held these papers until redemption. However, few retail or institutional investors hold such instruments until maturity – though pension funds do often match pension liabilities against portfolios of long-term instruments. (That is the reason why annuity rates are still falling.) Instead, most churn their bond portfolios so as to profit from short-term price fluctuations. For example, the price of the Austrian 100-year bond has doubled in the last 10 months – a superb investment for those who rode it.

But it is a very strange world where Germany can issue a 30-year bond with a coupon of zero – as happened last week. What do investors think they are doing by buying such bonds? I’ll suggest an answer at the end of this piece.

At last weekend’s confabulation of central bankers at Jackson Hole, Wyoming, the consensus was that interest rates are not going to rise any time soon. There was clear concern about the prospect of “no-deal” – as between the USA and China, that is. Jerome Powell underlined the risks associated with the convergence of a trade war, a no-deal Brexit, possible recession in Germany, the turmoil in Hong Kong and the collapse of the Italian government. He intimated the need for further imminent “stimulus”.

Another aspect of the US role in the global economic system that exercised the priestly caste at Jackson Hole was the status of the dollar in the international monetary system. The US accounts for only 10 percent of global trade and 15 per cent of global GDP but the dollar is used to price half of all trade invoices and two-thirds of global securities issuance, Bank of England Governor Mark Carney said. He argued that this created distortions in the global monetary system.

For the first time in public, Mr Carney proposed that a state-controlled digital currency might prove to be the only antidote to dollar dominance. (That is precisely what I have been saying in these pages for some time!) He further suggested that rates might be cut in the UK in the event of no-deal on 31 October.

Inflation versus deflation

In “normal” conditions interest rates tend to rise when the economy starts overheating – that is to say, when it is operating at close to full capacity. That is to forestall inflation. Historically, interest rates naturally exceed the inflation rate by a good margin so that real rates remain positive. In the unusual era in which we have lived since the financial crisis of 2008-09, real interest rates have often been negative. Currently in the UK, for example, the level of inflation as measured by the consumer price index (CPI) is running at about 2 percent[i] while the Bank of England Base Rate remains stuck at 0.75 percent. So the realrate of return on cash is actually negative.

In the short-term, the markets fear that “frictions” on the UK-EU borders in the event of a no-deal Brexit could cause shortages, especially of foodstuffs, which would push prices higher thus fuelling inflation. A falling pound would make UK imports more expensive, as would new tariffs – though there would surely be a degree of import substitution.


Moreover, UK government spending is likely to be ramped up next week when Mr Javid will unveil his spending plans for the next year to the House of Commons. He has stated that he will not allow the UK fiscal deficit to rise above 2 percent of GDP – but that represents a substantial rise from the current 1.1 percent level. The markets certainly seem to think that inflation is likely to pick up. A surge in rates in the swaps markets suggests that UK inflation could even reach 4 percent by the end of this year.

Globally, some fund managers such as Ruffer LLP fear that central banks might “overshoot” and that by lowering interest rates to inappropriate levels they might unleash the hounds of inflation. This could even coincide with an external shock – one scenario might be an intensification of tensions in the Gulf which pushes oil prices higher. Ruffer recommends exposure to index-linked bonds as an insurance policy.

With UK index-linked bonds, the value of interest paid and the maturity value of the bond increases in line with inflation – but decreases in the event of deflation. The US equivalent, TIPS (treasury inflation-protected securities), in contrast, compensate investors for the effects of inflation but do not penalise them for deflation. UK investors cannot access TIPS directly but can invest in synthetic funds which track them. One such is the iShares Tips Ucits ETF. This is US dollar denominated, but a currency hedged version of the fund is also available.

But other investors are equally convinced that deflation remains the real enemy. David Kauders of Kauders Portfolio Management which specialises in capital preservation strategies has been saying that while central banks have been trying to stimulate limited inflation for the last ten years they have essentially failed. That is not going to change any time soon.

UBS Group (SWX:UBSG), the world’s largest private banker, with over £2 trillion of assets under management, has shifted to an overall negative stance on equities. If that view takes hold there could be an outflow of funds from the equity markets only for those funds to be reinvested in bonds. That could drive bond yields down even further.

The bid to save the German saver

As the ECB prepares to cut interest rates to stimulate the eurozone’s faltering economy, the German Ministry of Finance is drawing up plans to protect German savers from further rate cuts. The current key rate in the eurozone (the rate at which the ECB lends overnight money to banks) is at minus 0.4 percent. That means that few eurozone banks can offer savers more than a paltry return on their nest-eggs and indeed many are being charged for the privilege of depositing their money in the bank. The ECB has signalled that it will most likely drop this rate to minus 0.6 percent in September and will resume quantitative easing (QE) at a level of around €30 billion a month. (Madame Lagarde, who takes the helm next month, may have something to say about that.)

German Finance Minister Olaf Schulz was reported last week to be exploring ways to shield German savers from further rate cuts. Bavaria’s Social Christian Union, the sister party to Frau Merkel’s CDU, has already proposed a ban on negative interest rates on deposits of less than €100,000. But the German Savings Bank Association has said that while talk of such a ban is well intentioned it would make matters worse.

Meanwhile, there is an ongoing case before the German constitutional court the backers of which are challenging the legality of QE itself. (Maybe they should engage the services of Ms Miller!) Many Germans now believe that the ECB has exceeded its mandate.

All this is happening as Germany teeters on the brink of recession. Growth in Q2 was minus 0.1 percent given falling industrial production. Business confidence is in free fall. But if borrowing costs are even lower than economic growth then, so some economists argue, there is a strong case for a fiscal stimulus – much more so than in more indebted eurozone countries. But the German establishment believes that this would be a bad example to less provident neighbours.

Impact on the German banking sector

There is also increasing concern in Germany about the impact of further rate cuts on the banking sector. The German banking sector is already experiencing acute turbulence that is threatening the core base of 1,400 savings and community banks which have served the Mittelstand of Germany’s family-owned businesses for so long. Germans believe in the utility of relationship banking – something which has largely been lost in the UK.

Another concern is that renewed QE on the part of the ECB will have the effect of pushing German credits in the Target 2 internal payments system above the €1 trillion level. Target 2, as regular readers of this column will be aware, is part of the hidden financial plumbing of the eurozone. Trade surpluses or deficits between eurozone members are accumulated at the central banks of each member country (which still function even though they do not issue currency – that is the preserve of the ECB).

Germany generates a trade surplus each year equal to about 8 percent of GDP – by far the largest in the world. That makes the German economy uniquely sensitive to a global slowdown. About a quarter of all cars sold in China are German. 40 percent of Volkswagen’s (ETR:VOW) global production goes to China as does about a third for BMW (ETR:BMW) and Daimler AG (ETR:DAI). German car production plunged by 18 percent last year from 5.7 million to 4.7 million vehicles.

In many ways Germany is a victim of the cult of globalisation. Domestic consumption now accounts for just 51 percent of its GDP – down from 63 percent in 2005. This flows directly from the introduction of the euro – a means by which German industry was able to remove exchange rate risk for its export sector while enjoying huge competitive advantages vis-à-vis the other 18 members of the eurozone.


In April 2007 Deutsche Bank’s shares hit €153. They are trading as I write at €6.43. So they have lost 96 percent of their value in just over 12 years – a disastrous investment, by any standard. This is partly due to the low interest rate environment that has undermined the bank’s entire business model – which, in turn, is largely a function of the deflationary currency union which Germany herself championed.

An inverted yield curve

As everybody knows, the yield curve in the US treasury market has been flat for a long time and has recently adopted a modestly negative slope – especially when adjusted for inflation. The “real yield” on the 10-year Treasury was 2.75 percent in 2007, about 1 percent in the autumn of last year but is now near zero. The UK government bond yield curve also flipped in August for the first time since 2008.

Popular financial wisdom holds that an inverted yield curve betokens a recession. That is because it suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. Yet the employment data in the US, the UK and Germany are excellent and consumer spending is buoyant. What is going on?

One possible explanation is that the enormous build-up of private and public sector debt globally implies that future defaults – and a systemic financial crisis – can only be avoided if indebted companies and governments moderate their future spending commitments over time. That implies a further economic slowdown. And that, in turn, incentivises central banks to cut short-term rates and to engage in further QE.

So, the global financial system has become a dog chasing its own tail. How long can that go on? As economist Bernard Connolly has argued[ii], low interest rates mean higher consumption today – but lower consumption tomorrow. As surely as night follows day there will be a price to pay.

USA: relaxation of the Volcker rule

The Volcker rule, imposed by the former Chairman of the Federal Reserve when he was heading the President’s Economic Recovery Advisory Board after the financial crisis, was a measure to stop big banks from speculating with their own funds in so-called proprietary trading.

Earlier this month, Jelena McWilliams, Chair of the Federal Deposit Insurance Corporation (FDIC) which is responsible for implementing the Volcker rule, said that it was “extremely difficult” to distinguish between what constitutes proprietary trading and what does not. Moreover, the costs of compliance for banks that trade little were substantial, she said. She implied that the enforcement of the rule would be relaxed.

Two years ago President Trump declared that the Dodd-Frank Act (2010) “made it impossible for bankers to function” and ordered a review of the Obama-era reform. US bank shares soared. Bank regulation is always a fine balance between preventing reckless lending behaviour and not tying banks up in red tape and thus stifling credit creation. It seems that the pendulum has swung back from banker-bashing to “light-touch” regulation – but at a very dangerous moment for the global economy.

Standard and Poor’s estimates that there is now a one-in-three chance of the US entering a recession during the next 12 months. So far the Fed has made just one modest cut in US rates this year – the first in a decade, so a symbolic one. Nevertheless President Trump branded Fed Chairman Powell “an enemy” (along with China) in an outburst on Twitter on 22 August.

Near-zero interest rates incentivise banks to take on more risk in a relentless search for yield. Banks’ return on capital is in precipitous decline. The inverted yield curve deprives banks of the opportunity to borrow cheap short-term funds and lend out more expensive medium-term finance.

The real message

Whichever way we cut and slice the issue, the fact that institutional investors are prepared – even content – to invest money in sovereign bonds with zero to negative returns tells us that they are afraid. Of what, exactly?

They fear that equity markets look toppy after a decade-long bull run. The returns on cash are negligible yet involve a tangible and growing level of risk. That is that the banking system might seize up again as it did in 2008 leaving investors unable to access their cash – or, even worse, that the end-point of the decline of the banking sector will be a systemic banking crisis sometime in the medium-term.

Better to be owed money by the German state than by poor old Deutsche Bank. That is why the banking sector is still contracting, thus removing liquidity from the financial system. That is likely to impact economic growth adversely as companies become less able to finance new investment projects.

Bond yields are only partly a function of interest rate expectations; they are, more importantly, a measure of relative default risk. In the eurozone in particular, the current absurdly low yields on government bonds reflect deep and existential fear concealed behind a smiling mask.

No wonder seasoned investors like our very own Jim Mellon are pivoting towards gold and silver. (Though, personally, I would rather own agricultural land to gleaming ingots.) On that, more soon.

[i]https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/may2019

[ii]See: Central banks trapped on path to Communism, Daily Telegraph, 24 August 2019. Available at: https://www.telegraph.co.uk/business/2019/08/23/central-banks-have-trapped-us-conveyor-belt-communism-disaster/(Paywall).