“It’s an absurdly odd world and it signals two things,” said investment banker Daniel Alpert, managing partner at Westwood Capital. “There’s an obvious, persistent and continuous glut of underutilized capital and there’s no place in the advanced world for that capital to be invested without excess risk.”
While recent economic data suggests that manufacturing, in particular, is cooling, the interest rates paid by bonds, known as yields, usually collapse only during times of serious economic stress, such as the Great Recession or the crisis that hit Europe two years later.
Today, Japan and seven major European governments, including Germany and France, are able to sell bonds with negative yields, as are corporate behemoths Nestlé and Sanofi, whose size gives investors confidence they could withstand a downturn.
The United States hasn’t seen such upside-down bonds yet, though the yields on U.S. government debt have plunged, contributing to the deep market sell-off Wednesday as key bond yields fell sharply. In recent days, top analysts at two giant investment houses — Pacific Investment Management Co. and JPMorgan Chase — have predicted that U.S. Treasury bond yields could go to zero or lower if the United States tumbles into recession.
Indeed, the trade war is intensifying bond market fears of the first global recession in a decade. After Trump tweeted on Aug. 1 that he was putting tariffs on an additional $300 billion in Chinese goods, more than $1.7 trillion of bonds slid into negative territory over the next week, according to data compiled by Bloomberg.
An investor who buys a bond is effectively lending a company or government money. Bond buyers typically demand a rate of return, or yield, to compensate them for the use of their money and the risk that inflation will erode the value of the payments they receive over time.
Bond yields and prices move in opposite directions. So falling yields mean that more and more investors are piling into the bond market, driving up bond prices.
Outside the United States, 43 percent of bonds are trading at a negative interest rate, up from 20 percent late last year, according to Deutsche Bank Securities.
Negative yields on bonds first appeared in 2014 after the European Central Bank cut its main interest rate below zero and began buying bonds in a bid to goose the economy. The promised return on Germany’s 30-year bond plunged below zero earlier this month for the first time ever.
The bond market’s ills demonstrate that the indirect effects of Trump’s trade war may be more costly to the global economy than the tariffs he has imposed or threatened on goods from China, Mexico, Canada, the European Union, Japan, India, Vietnam and Guatemala.
Fallout from the president’s unpredictable trade offensive is driving up the danger of a recession before the 2020 election, economists say, with a closely watched Federal Reserve Bank of New York gauge putting the chances at almost 1-in-3 over the next 12 months.
“In the short term, at least, most of the economic damage from the tariffs is likely to stem from the indirect effects on things like business confidence and investment rather than the direct effects on trade flows,” Neil Shearing, chief economist at Capital Economics, wrote in an Aug. 8 research note. “These indirect effects are difficult to measure and can extend beyond the countries imposing tariffs on one another.”
Federal Reserve Board Chair Jerome H. Powell cited “trade policy uncertainty” last month in cutting the benchmark lending rate by one-quarter of a percentage point. Four more central banks — India, New Zealand, Thailand and the Philippines — followed suit last week. The European Central Bank is expected to join the rate-cutting and perhaps resume its asset-buying program before the end of the year.
“The escalation of trade tensions has been one of the factors driving a new global easing cycle by central banks,” Mohamed El-Erian, chief economic adviser for Munich-based Allianz, said in an email. “It’s a race to the bottom for global interest rates, with no one really wishing to see their currency appreciate given the weakened growth outlook for the global economy.”
Those rate cuts are another factor driving demand for bonds and helping to push interest rates into negative territory.
The emergence of negative-yield bonds is a consequence of the ECB’s efforts to fight lingering economic weakness by slashing interest rates and buying $3 trillion in bonds. Likewise, the Japanese central bank, the Bank of Japan, took action to push down rates in January 2016 with similar effects.
The spread of subzero bonds erodes profits for banks and may make it impossible for some insurance companies and pension funds to earn enough from their investments to meet their obligations to policyholders and retirees. Some insurers could fail while banks cut back on making loans, starving the economy of fuel needed for growth.
“This is a credit crunch. And a credit crunch is a known economy-killer,” said economist Carl Weinberg of High Frequency Economics.
If these unusual financial conditions persist, the economic costs are likely to mount. Offering credit at negative rates distorts incentives for investment, potentially fueling asset bubbles that could pop with devastating consequences.
The Bank for International Settlements in Basel, Switzerland, an organization of central banks, has linked ultralow interest rates to the emergence of “zombie” firms. These are unproductive companies that would fail if debt costs were at normal levels. Instead, they linger, hogging investment and workers that could be put to more productive uses, according to the BIS.
“You can survive, quote-unquote, or can live with negative yields for quite some time. Indefinitely? It would be very odd to think about that being possible. There would be distortions in the economy,” said economist Claudio Borio, head of the monetary and economic department at the BIS. “You will have resources in the wrong sectors, in the wrong firms, and therefore productivity and growth will suffer. On top of that, you’re likely to have quite a lot of debt out there, which will make it harder for policymakers to raise rates without creating some tensions and problems.”
Indeed, the prevalence of negative yields is complicating central banks’ management of the economy. In Europe, ECB President Mario Draghi hinted at more monetary policy easing ahead, which would probably deepen the bond market’s negative turn.
Europe’s central bank chief said last month that euro-zone rates will remain at or below current levels through the first half of next year, and he raised the possibility of restarting the program of quantitative easing or bond-buying that he shuttered only last year.
“If interest rates keep going down, the banks will be under pressure. If they go up, governments will be under pressure,” said economist Ashoka Mody, a former International Monetary Fund official. “They’re caught in a bit of a pincer.”
The Fed’s main lending rate, meanwhile, is just 2 percent to 2.25 percent, well below historical norms. If Powell keeps cutting, as investors expect, the Fed will have little ammunition left to fight the next recession.
For now, the 10-year U.S. Treasury remains in positive territory, though well below the long-term average yield of 6.1 percent since 1961. The yield has fallen to 1.7 percent from 2.8 percent in January, an indication that bond investors do not share the president’s optimism about the economy.
“Our country is doing fantastically well,” Trump said Aug. 9. “You look at Europe; they’ve got problems. In fact, the biggest problem we have is the fact that a lot of other — continents, frankly — but a lot of other countries are not doing well.”
Some analysts say the U.S. bond market will never go negative. But others see a much more perilous scenario in which the U.S.-China trade war festers, chilling global trade and slowing growth worldwide. Economic weakness infects the United States, prompting the Fed to slash rates to zero and restart its own program of asset purchases.
In that environment, the nearly $16 trillion U.S. Treasury market could get drawn into the vortex of negative rates, triggering a dangerous financial malady.
“It seems very fragile at the moment,” said Torsten Slok, chief economist at Deutsche Bank Securities. “We’re walking on a tightrope.”