The Bond Market Gets Curiouser and Curioser

Sometimes the smartest thing is to do nothing.

This column has been pretty harsh on the Federal Reserve for its failure to start tightening monetary policy, as it sort of promised it would back in December. Since then, there’s been a steady stream of “yes we will, no we won’t” pronouncements from the Fed – both from the Fed itself and its individual members – that have left investors confused about the direction of U.S. monetary policy. Now, nine months later, the Fed has still not made the next move in “normalizing” interest rates.

A Reuters survey released last week found that 69 of 95 – that’s nearly three out of four – economists don’t expect the Fed to raise rates until December, after the presidential election, followed by two more hikes next year. We’ll see.

But even if the data-dependent Fed doesn’t do that and continues to wait, at least it’s not doing untold damage to our economy like its central bank counterparts around the world are doing. Just look at the mess the European bond markets are in right now.

Last week the yield on Spain’s 10-year government bond fell below 1% for the first time ever, closing the week at 0.93%, down 84 basis points so far this year. That leaves only four euro zone countries—Italy, Portugal, Cyprus and Greece—with 10-year bond yields above 1%. But Italy is poised to go below that mark soon: its 10-year bond closed last week at 1.05%.

By comparison, the yield on the benchmark 10-year note of the U.S. Treasury—arguably the most rock-solid credit in the world—closed last week at 1.51%. In other words, the U.S. government is paying half again as much as the governments of Spain and Italy—long derided as “peripheral” Europe and fairly dicey credits—to borrow money.

But that paled in comparison to what was happening in the United Kingdom, the “new engine of bond market distortion,” as the Wall Street Journal called it. There, the yield on the 10-year gilt dropped to 0.52%, 144 basis points lower than where it ended last year and a full percentage point below the U.S. Yields on short-term British paper fell below zero.

What caused that to happen? The Bank of England’s new quantitative-easing bond purchasing program to help ease any pain emanating from the U.K.’s exit from the European Union. The BOE couldn’t find enough bonds to sate its appetite because investors, mainly financial institutions who need the bonds to meet their own and their clients’ investment obligations, won’t sell, which has driven up the price of gilts. Long-term gilts have returned more than 30% this year as prices have soared.

Meanwhile, the gold standard of the European sovereign bond market, the German 10-year Bund, is trading at negative 0.11%, the exact same rate as its Japanese counterpart.

The value of negative-yielding bonds worldwide has now reached more than $13 trillion, according to Tradeweb. Most of that debt is government bonds in Europe and Japan, but also an increasing amount of high-grade corporate bonds.

And who do we have to thank for this state of affairs? Why the BOE, the European Central Bank and the Bank of Japan.

“It’s surreal,” Gregory Peters, senior investment officer at Prudential Fixed Income, told the Financial Times. “It’s clear that central banks are dominating markets. It’s extremely distortive.”

That’s an understatement. And it gets even worse.

Last week Germany sold what The Wall Street Journal called a “strange new breed” of zero-coupon bonds – and found investors to buy them.

Traditional zero-coupon bonds are sold at a deep discount to face value, and when the bonds mature the investor gets back more than what he paid for them, including accrued interest. For example, he pays $90 today and gets back $100 20 years from now. But in this “new mutation,” the German bond is sold above par, guaranteeing the investor a loss if he holds it to maturity. In other words, the investor willingly pays, say, $100 for the bond and gets back $90. What a deal.

“The crucial thing to understand is that these instruments are no longer bonds—at least not in the traditional sense,” the Journal noted. “With no income attached to them, they are simply bets on the price another investor is willing to pay. They will also be more volatile: the long wait for repayment means small changes in yield will have a big effect on current prices.”

Now negative interest rates have started to creep into the consumer sphere. Bloomberg reported that a small cooperative savings bank in Bavaria had started charging a 0.4% fee on retail savings balances greater than 100,000 euros ($111,710).

“With our business clients there’s been a negative rate for quite some time, so why should it be any different for private individuals with big balances?” a bank official said, noting that deposits below that figure wouldn’t be charged the fee – at least not yet.

It’s bad enough that depositors in most of the so-called advanced economies are getting next to nothing on their invested savings. Now even that is no sure thing, leaving many people with the option of parking their money in safes and mattresses or losing money in the bank.

Fortunately, our Fed hasn’t succumbed to this nuttiness, and hopefully, it never will. Maybe simply doing nothing is the best strategy in a financial world gone mad.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.