Authored by Komal Sri-Kumar, op-ed via Bloomberg,
With some $13 trillion of bonds worldwide yielding less than zero percent, it would be easy to characterize fixed-income assets as nothing more than a giant bubble waiting to burst. Those who agree probably haven’t heard of the concept of a “Giffen good.”
Simply put, a Giffen good is a paradox of economics where rising prices lead to higher demand, which is in contrast to the negatively sloped demand curve that students learn in Economics 101. Named after 19th century Scottish economist Sir Robert Giffen, a Giffen good is typically an essential item that, because of its higher price, leaves less resources to purchase other items. (To be sure, many economists debate whether a Giffen good actually exists.)
In terms of the bond market, it’s important to understand that the rapid plunge in yields, especially for sovereign debt, reflects increased concern about the state of the global economy. Those concerns, in turn, only fuel demand for the safest assets even at negative yields, which pushes prices higher and yields even lower.
There are three more reasons why sovereign bonds have become a Giffen good.
First, inflation rates have been low or declining in the U.S., euro zone and Japan, encouraging investors to allocate more resources to fixed-income assets despite falling yields. High rates of inflation reduce the purchasing power of bond holders, but low rates of inflation do the opposite.
The Federal Reserve’s target of a 2% inflation rate has not been consistently met for more than a decade, and we learned Friday that average hourly earnings of U.S. workers over the past year increased by only 3.1%, less than consensus and continuing to decelerate from a rate of 3.4% earlier this year. The European Central Bank’s 2% inflation target remains a distant dream with prices rising by 1.2%. Japanese consumer prices rose by a mere 0.7% in May.
Second, expectations for central bank monetary policy have been kind to bond investors. Ten-year yields have fallen below policy rates in the U.S., Germany and Japan, providing a reason – and pressure - for monetary authorities to reduce rates. Fed Chairman Jerome Powell bluntly stated in his testimony to Congress this week that the latest month employment report, which showed that the economy added a healthy and greater-than-forecast 224,000 jobs in June, would not prevent the central bank from cutting rates in the near future.
In Europe, the nomination of International Monetary Fund Managing Director Christine Lagarde to become the next President of the ECB was a factor in last week’s drop in yields. Lagarde has been supportive of asset purchases by the ECB, and is widely expected to commence a new quantitative easing program when she assumes her new role on Nov. 1.
Third, the steep decline in U.S. and German risk-free yields have increased the attractiveness of lower-rated sovereign credits. As investors reached for returns, Greek five-year yields have fallen from 1.66% to 1.24% over the past month. Even more dramatic was the draw of Italian 10-year notes, whose yields dropped by 66 basis points over the past month to 1.70%.
And as the Fed, ECB and the Bank of Japan lower interest rates or accelerate asset purchases, don’t expect the global economy to respond positively. Instead, such moves are only likely to increase investor concern about the health of the global economy, which could become a sort of self-fulfilling prophecy and tamp down inflation expectations even further. Such a scenario would cause central bankers to lean toward even more easing, raising the odds of a “Japanification” of the global economy.
Investors would be better off ignoring advice that suggests today’s low bond yields make them unattractive relative to equities. The high prices and low yields of bonds acts as a magnet and is likely to be a gift that keeps on giving for the bulls.