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Not a ‘bond bubble’ but a call for action

What’s the fastest-growing asset class so far this year?

Negative-yielding bonds that, if held to maturity, are guaranteed to impose a loss on investors.

The stock of negative-yielding bonds has almost doubled since the start of the year to USD16 trillion, amounting to some one-third of global bonds.

Many commentators have dismissed the dramatic fall in bond yields and rise in negative-yielding debt as evidence of a ‘bond bubble’. But negative-yielding debt is not a reflection of investor ‘irrational exuberance’. It is a call for politicians to act to prevent a deflationary global economic downturn.

The explanation for the dramatic decline in high-grade government and corporate bond yields worldwide, and surge in negative-yielding debt, is that investors are rationally responding to the rising risk of a deflationary global recession.

Business confidence and investment are being eroded by the uncertain ebb and flow of the US-China ‘trade war’, the threat of US tariffs on autos, Brexit and the slowing Chinese economy that has been the bedrock of growth for many global and especially European manufacturers.

Falling bond yields globally is fuelled by investors’ desire to hedge their growth-sensitive risk assets against the backdrop of rising uncertainty and ‘late cycle’ fears, rather than a central bank engineered indiscriminate ‘grab for yield’.

The US Federal Reserve (Fed) ‘dovish pivot’ at the start of the year and subsequent policy easing by the ECB and other central banks has lowered actual and expected short-term interest rates. Long-term real inflation-adjusted rates have also declined as investors revise down global growth potential in response to the populist backlash to globalisation and liberalisation.

What is also different this time is that at this stage of the business cycle, the Fed is the only major central bank with room to meaningfully cut interest rates – albeit much less than in previous downturns.

Policy rates in Europe and Japan are effectively at their lower bound beyond which further cuts will constrain credit supply and encourage saving rather than investment as well as pose risks to financial stability.

A consequence of negative policy rates is the rise of negatively yielding debt that challenges the business model of financial institutions. Investors are forced to take on more duration, rendering the ‘safe’ assets in their portfolio vulnerable to even a modest back-up in bond yields.

Investors are rightly sceptical that marginal cuts in interest rates and more quantitative easing pulling bond yields even lower will meaningfully raise inflation expectations and boost spending against the backdrop of greater uncertainty around global trade and growth and declining profitability. Reduced uncertainty around trade policy, including the lifting of the threat of US auto tariffs, and growth-friendly fiscal policies are required to lift business confidence and boost demand.

ECB President Mario Draghi recently stated that if there were a worsening in the euro-zone economy, “significant fiscal policy becomes of the essence”.

The eurozone bond market is loudly shouting that fiscal policy is too restrictive and by way of encouragement is offering to pay the German government and others to borrow and spend. A debate on fiscal stimulus by the eurozone’s largest economy is underway in Berlin, but it lacks the urgency that investors are calling for and that the deteriorating German and eurozone growth outlook warrants. And the Japanese government should again defer its planned hike in sales tax in October.

Government bonds remain an important diversifier of the growth risk in investor portfolios despite low and negative yields. But investors must also be wary of painful market losses from even a partial ‘normalisation’ of interest rates against the backdrop of current ultra-low yields and lengthening bond maturities.

For bond investors seeking income, there is little choice but to actively exploit shifts in term premium, volatility and idiosyncratic country and corporate credit risk.

Asset bubbles are characterised by cheap money fuelling a credit-financed rise in asset prices to levels not matched by fundamentals with the prospect of further price appreciation justified by increasingly outlandish claims of ‘this time it’s different’.

But the dramatic decline in bond yields and surge in negative-yielding debt is a call for fiscal policy to support growth. Monetary policy is not yet wholly impotent, but politicians must heed the call to reduce trade tensions and pursue growth-friendly fiscal policies.

Sooner or later governments rather than central banks will have to take the lead.

This content was first published in the Financial Times on 26 August 2019.