Friday's unprecedented surge to all time highs in both stock and treasury prices, has got analysts everywhere scratching their heads: which is causing which, and what happens if there is a violent snapback in yields like for example the infamous bund tantrum of May 2015.
But first, the question is what exactly will pause what the WSJ calls the "Black Hole of Negative Rates" which is dragging down yields everywhere. Here is how the WSJ puts it:
The free fall in yields on developed-world government debt is dragging down rates on global bonds broadly, from sovereign debt in Taiwan and Lithuania to corporate bonds in the U.S., as investors fan out further in search of income. Yields in the U.S., Europe and Japan have been plummeting as investors pile into government debt in the face of tepid growth, low inflation and high uncertainty, and as central banks cut rates into negative territory in many countries. Even Friday, despite a strong U.S. jobs report that helped send the S&P 500 to a near-record high, yields on the 10-year Treasury note ultimately declined to a record close of 1.366% as investors took advantage of a brief rise in yields on the report’s headlines to buy more bonds.
As yields keep falling in these haven markets, investors are looking for income elsewhere, creating a black hole that is sucking down rates in ever longer maturities, emerging markets and riskier corporate debt.
"What we are seeing is a mechanical yield grab taking place in global bonds," said Jack Kelly, an investment director at Standard Life Investments. " The pace of that yield grab accelerates as more bond markets move into negative yields and investors search for a smaller pool of substitutes."
As a result of this "mechanistic scramble", as we noted on Friday citing the latest BofA analysis, there is now $13 trillion of global negative-yielding debt. That compares with $11 trillion before the Brexit vote, and barely none with a negative yield in mid-2014.
Needless to say, this is a problem:
The ever-widening rush for yield could create problems if interest rates snap back, which would cause losses on investors’ low-yielding portfolios, or if credit quality falls. And the global yield grab is raising questions about whether rates can prove reliable economic indicators.
Without saying it, the WSJ also admits the bond market is now completely broken, as it no longer responds to traditional signals:
The yield grab is spreading to bonds that have a riskier profile. The more investors search for yield, the more bond yields fall. “It’s a bit self-fulfilling,” said Iain Stealey, a fund manager at J.P. Morgan Asset Management.
Even as yields fall in emerging-market debt, for instance, the credit quality of some of these countries is falling, analysts say. Sovereign credit ratings are on track for a record number of downgrades this year as declines in commodity prices hit emerging economies, according to Fitch Ratings. The credit-ratings firm has downgraded 15 nations in the first half of the year, compared with a previous high of 20 downgrades for the whole of 2011, around the peak of the eurozone credit crisis.
Changes in monetary policy could also trigger potential losses across the sovereign-bond world. Even a small increase in interest rates could inflict hefty losses on investors. With the 2013 “taper tantrum,” for instance, the Federal Reserve sparked a selloff as it discussed ending its bond-buying program known as quantitative easing.
A repeat “would be very painful for a lot of people,” said Mr. Stealey of J.P. Morgan. “The market has got very comfortable with fact the yields aren’t going anywhere.”
How painful? Here is the breakdown. As Goldman calculated one month ago, a 100bp shock to interest rates would translate into a $1trn market value loss. That is using the more conservative estimate of the bond market. Using the broader bond market sizing of $40trn, the market value loss estimate would be $2.4 trillion.
That's a massive MTM loss for those who still do in fact, mark to market.
How about bonds? For the answer we present a table we have shown in the past, namely the convexity of fixed income products, where a 1% rise in yields would have a disproportionate hit on various debt classes. Here is the summary:
Looking at Treasuries, a 1% increase in yields would result in the following price losses:
- 2Y TSYs: -2.0%
- 5Y TSYs: -4.7%
- TIPS -4.9%
- 10Y TSYs: -8.7%
- 30Y TSYs: -19.2%
Other debt products fall in this range:
- Convertibles: -2.9%
- MBS: -3.5%
- US Junk bonds: -4.3%
- Total US debt: -5.4%
- Munis -5.6%
- And Investment Grade corporates: -6.9%
For now, however, few are worried about the risks, and instead everyone is piling into even the smallest yielding products. As the WSJ puts it:
Ricky Liu, a high-yield-bond portfolio manager at HSBC Global Asset Management, said his firm has clients from Asia who are willing for the first time to invest in portfolios that include the highest-rated junk bonds. Today’s yield grab could be setting up tomorrow’s problems.
Sadly, as the market has done ever since the Fed and central banks took over, "tomorrow's problems" will be address when they occur: tomorrow. Meanwhile, investors hope that no matter what tomorrow brings, the Fed will once again do what it has done every time "problems" emerged. Fix them.