Maybe the recently detected gravitational waves are not only rippling across the fabric of the space-time continuum, but also distorting the US bond market. If it’s not that, how can we be setting new record lows in 10-year Treasury yields with the unemployment rate at a lean 4.9%, and the Fed having at least started a rate hike cycle?
There are four possibilities that don’t require an appeal to black holes in investors’ minds. First, it could be that real rates aren’t really that low, because investors have concluded that US inflation will be extremely low for a decade. Breakeven inflation rates in the TIPS market have indeed fallen, although it seems hard to reconcile a new and much lower view on inflation for a full decade with the long-awaited uptick we’ve just seen in wage rates.
Alternatively, the market may be drawing an analogy to Japan and Europe, judging that the US can grow, but only if nominal and real rates stay extremely low for a long time. But Europe has a much larger output gap and a persistent political leaning to tighter fiscal policy, requiring a monetary offset. Japan also recently tightened fiscal policy in the face of a 200% debt/GDP ratio. It also has a declining working age population and barely positive potential growth, and therefore gets little capital spending even at low rates, given the lack of any need to expand capacity for domestic demand. Neither of these Eurozone or Japan stories fit the US that well.
A third alternative is that there’s a growing minority of investors who feel the US is on the precipice of recession, so that even if low rates aren’t forever, we’re going to need negative policy rates soon to address a cyclical downturn. A soft Q4 did indeed cast some doubts, as did the equities correction. Recent data on retail sales, employment, hours worked, confidence and jobless claims should have allayed some of those concerns, but didn’t. Yellen noted downside risks from abroad, and these are prevalent enough that we no longer see the Fed hiking until mid-year. But she didn’t sound ready to think about an ease. Yellen only discussed negative rates because she was asked about them, and sounded unenthusiastic.
A final theory is that the market sees the US as in decent shape, but is rushing to Treasuries in a flight to safety bid from stocks and corporates. One could be worried enough about stocks, EM dollar-denominated debt, energy sector debt in dollars, and the lack of liquidity in other debt instruments to not only push yields higher on those spread products, but pressure Treasuries lower. Still, these investors could roll short term bills instead of taking on the duration risk of a 10-year bond if they felt that Fed hiking was still in the cards over the next few years.
So, with nothing more solid to go on, maybe we do have to invoke gravitational waves after all. The merger of the colliding black holes responsible for the wave lasted less than a third of a second. If, as we expect, the US economy holds up reasonably well in 2016, credit troubles are concentrated in a few sectors like energy, core inflation inches higher, and the Fed resumes tightening before year end, new records for Treasury yields won’t last that long either.