The Race to Zero and Below

Aka: the “Case of the Missing Interest” or “The Inverted Yield Curve Goes Mainstream”

I need to apologize in advance if I overuse superlatives in this post.  The thing is that when I look at what is going on in the world of bonds and interest rates, it just seems nearly incomprehensible to me.  Admittedly, as the post-modernists would say, I have to account for the fact that I see through eyes that came of age (or at least graduated from college and entered the working world) at a time when short-term interest rates were 20%.  But, it seems to me that as interest rates around the world collapse – with currently $16 trillion in bonds sporting negative yields –  it really doesn’t matter when you began paying attention to interest rates.  This has never happened before:

• Germany. All German government bonds across the entire maturity spectrum (out to 30 years) have negative yields – the German government is getting paid to borrow money!  That is stupefying to me!
• Switzerland.  Recently Swiss 50-year bonds were actually negative yielding.  Lenders were actually willing to lock in a 50-year loss.  Though, I must admit that in the short-run they could make money if rates go more negative than when they bought the bonds and they then sell them at a profit.  I can’t see that being an attractive money-making strategy.
• Denmark.  Just this week the news spread that a Danish lender was offering mortgages at negative 0.5%!  We should all buy new houses and have the bank pay us to do it! Though, apparently, the fees eat up the negative rates bringing the true borrowing rate all the way up to close to 0%!
• United States.  The 30-year Treasury bond just broke to new all-time lows below 2%!  30-year rates below 2% at a time of the longest economic expansion in history with the lowest unemployment rate in half a century.  That’s hard to understand.

Inverted Yield Curve

All of a sudden it seems like the Treasury yield curve has become a hot topic.  In fact, during the 800 point down day in the Dow Jones Industrials earlier this week, President Trump even tweeted, “Crazy Inverted Yield Curve”.  What’s going on?  What is an “inverted yield curve” and why is everybody talking about it?

1. Simple Definition. An inverted yield curve is a situation where the yield on a Treasury of shorter maturity yields more than a longer maturity.  This is unusual because typically an investor (bond buyer) requires higher yields to be willing to tie up their money for longer periods.  For example, so far this year, the 3-month and 6-month Treasury bills have been yielding more than the 10-year Treasury for months.  This section of the yield curve has inverted.
2. Explanation.  This can get complicated, but conceptually you might think of it as investors assuming that rates will be lower in the future.  So, they may be willing to forgo the higher returns currently available on short-term bills to lock in a rate for 10-years that they expect to return more than the average yield on short-term bills continually rolled over.
3. Why the big deal?  Well, the headline is that a widely-followed, key relationship just inverted whereby the 2-year treasury began yielding slightly more than the 10-year (though it has since “un-inverted” slightly as I write this).  Historically, the inversion in the 2-year/10-year curve has often predicted recessions.  When this flipped Wednesday, the stock market emotionally reacted to the recession fears dropping about 3%.

This might be an overreaction as historically the span between the curve inversion and recession onset has varied greatly even extending well over a year.Furthermore, the collapse in interest rates as well as the recent sharp drop in energy prices will likely add some more stimuli to our economy by lowering costs for business.This might be enough to avert a recession in the near-term.

On the other hand, this is the longest economic expansion in history and the longest bull market in history, both of which have to end sometime.

Fanciful Daydream

For several years, as our government debt has exploded since the Great Financial Crisis to $22.5 trillion as I write this, I’ve read a great deal about how the interest on our debt will eventually crowd out all other spending as the debt keeps growing and rates eventually move higher.  However, just as a thought experiment, what if our interest rates join much of the rest of the world and go negative.  How about a plan to “refinance” our debt and turn it into a profit center?  Do you think the government could “float” a $22.5 trillion dollar bond issuance and get enough buyers?

It’s probably not going to happen.  Then again, I remember the turn of the millennium when we had been enjoying the budget surpluses of the President Clinton years, reading about how the surpluses would eventually destroy the government bond market.  That didn’t happen either.

I’m happy to say that I’ve done a phenomenal job of limiting the most extreme superlatives in this post. That’s probably because I’ve focused on the ho-hum stories of trillions of dollars of negative interest bonds instead of the very exciting prospect of the Chicago Cubs putting their road woes behind them and streaking to their second world series win in four years!  Super Duper!

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