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Curatia Analysis for Tue, Sep 10

Are Bonds in a Bubble?

“Sizzling” bond markets have been the center of attention this summer, with US Treasuries and corporate bonds in particular logging huge gains as risk-off sentiment prevails.

But even as elevated stock markets, recession fears, and expectations of easing by the world’s central banks propel bond prices ever higher, talk of a bond bubble has grown in recent weeks as investors mull the possibility that slowing economic growth could prove more ephemeral than once feared.

The Case Against

Bonds’ 2019 breakout continued in August, with US Treasuries and US investment-grade corporate bonds leading the charge. From March 1 to August 30, 10-year Treasury yields nearly halved from 2.759% to 1.499%.

US investment-grade bonds meanwhile had their best monthly performance in a decade in August, with an ICE investment-grade bond index returning 3.2%. $6.4B in fresh inflows for the week ended August 28 brought YTD inflows to $160B — far ahead of 2018’s $64B YTD total.

Risk-off sentiment fueled by rising fears of a global recession has triggered a stampede out of elevated stock markets and into bonds. In addition, many investors anticipating rate cuts by central banks around the world have raced to capture yield before such cuts, coupled with heightened investor demand, stamp it out.

Low yields have attracted debt issuers. Behemoths including Coca-Cola, Walt Disney, and Apple have flocked to bond markets to refinance existing debt at lower rates, issuing $74B of US investment-grade bonds in the first week of September alone — the most for any week since record-keeping began in 1972.

With more than $17T in negative-yielding debt worldwide, international investors are likewise turning to US markets to capture even modest returns. That movement has, in turn, attracted more debt issuers, creating a self-perpetuating cycle.

At the same time, central banks have begun taking measures to ease monetary policy. The People’s Bank of China cut banks’ reserve ratios Friday in a move expected to free up $126B in liquidity.

Investor expectations are high for a “barrage of stimulus” when the European Central Bank meets Thursday. And the Fed, the Bank of Japan, and the Swiss National Bank are all expected to cut rates when they convene next week.

Collectively, those forces are conspiring to paint a picture of global bearishness that will continue to push bond yields lower for the foreseeable future.

If that’s not enough, a high degree of economic policy uncertainty stemming from trade war angst, fears of a no-deal Brexit, and swirling tensions between China and Hong Kong, the US and Iran, and India and Pakistan creates a seemingly bulletproof case for continued bond buying.

The Case For

How, then, could we be in the midst of a bond bubble?

First and foremost, recent economic data has arguably pointed upward. In the US, Friday’s employment report showed the economy continues to add jobs, albeit at a slower rate.

Additionally, wage growth exceeded expectations — a result that will serve to discourage the Fed from an aggressive regime of rate cuts that could stoke inflation. Hours worked — seen as a proxy for how bullish employers are about growth prospects — ticked higher as well.

European economic sentiment also got a boost yesterday when British GDP (+0.3%) and Germany’s trade surplus (+0.7%) both surged unexpectedly.

Those results are giving oxygen to a swing in bond markets that has seen US 10-year Treasury yields creep up from 1.459% on September 3 to 1.64% yesterday.

They are likewise pushing markets to accept the Fed’s rationale for a quarter-point rate cut over a half-point cut when it meets next week. Market odds of a half-point cut have tapered from 40% in early August to single digits.

Crucially, the Fed has stuck with the assertion that rate cuts could be a temporary phenomenon rather than a lengthy easing cycle despite taking heat for doing so.

The self-perpetuating cycle of bond buying has also shown signs of having run its course. Companies rushing to issue new debt are implicitly betting interest rates will rebound. And some investors have pared long-term bond holdings in favor of other products like private debt and structured credit.

More broadly, lower yields should stimulate a surge in debt issuance by governments as well as corporations. An increased supply of bonds figures to pull yields up in the near term, while new financing for companies and states should stimulate economic growth in the medium term. Those dynamics lend weight to the Fed’s claim that its cuts are a “recalibration.”

Finally, some analysts have argued transitory factors have pushed yields lower. Hedging activity has “propelled a massive rally” in long-term bonds, according to The Wall Street Journal, causing bond markets to flash exaggerated recession signals. Summertime illiquidity further amplified those moves.

The cases both for and against a bond bubble thus both appear compelling — a state of affairs likely to stoke bond market volatility in the weeks ahead.