Are Western Bond Markets Turning Japanese?
It might only be a number or a psychological barrier for markets. But the 2 percent level that 10-year U.S. Treasury and German Bund yields have dived under in the past few days is hugely significant.
The only other big western government bond market to go below 2 percent in recent times was Japan. Since it dropped beneath that level in 1997, it has only risen above 2 percent for a few weeks in 1999 and an even shorter period in 2006. Otherwise Japanese yields have been marooned at historically low yields for the past 14 years.
That was accompanied by an extraordinary collapse in Japanese stocks with the Nikkei 225 now standing at under a quarter of its peak level of 1989.
It is a profoundly sobering thought for western investors who saw Treasuries yesterday hit their lowest yields since 1950 and Bunds their lowest ever while stock markets continued their summer slump. If it persists, it would threaten to change some of the main tenets of asset allocation and investing.
“It is decision time for investors,” says Rod Davidson, head of fixed income at Alliance Trust Asset Management in Edinburgh. “If you believe in a Japan-style situation, almost all bets are off. Equities suffer, corporate credit widens and you would want to own long-dated government bonds. But there are question marks over even that as you start to worry about the solvency of governments.”
But how likely is it that western bonds and equities do go fully Japanese?
Some investors, shareholders in particular, remain relatively cautious of making the suggestion, not least because of its implications. The comparison between bond and equity yields is one of the most frequently used valuation tools and a firm part of many asset allocation decisions. A continued slide in bond yields would turn this on its head.
However, if the past few decades of market history holds true, that leaves a large group of investors to believe that equities look better value currently than bonds. The FTSE indices for the U.S., UK and eurozone have dividend yields of 2, 3.5 and 4.5 per cent, according to FTSE data. That compares with US, UK and German 10-year government bond yields of 1.95, 2.3 and 1.81 per cent on Tuesday, according to Tradeweb.
“The level of bond yields themselves is not telling you that equities are a value trap,” says Mislav Matejka, equity strategist at JPMorgan. He argues that a crucial difference to Japan is that companies are “strong and profitable” in the west unlike the experience in the 1990s in Tokyo.
But others are gloomier, arguing that bond investors have been ahead of stock markets throughout the crisis. “Every time we have seen a divergence between the Treasury and equity markets, bonds have been right and it appears to be the case once more,” says Jack Ablin, chief investment officer at Harris Private Bank. “The current level of the S&P 500 is pricing in a decline of 20 per cent for earnings, but if we get a recession, I’m concerned that profits could fall further.”
Bond investors are by their nature more pessimistic, often doing well when fears about the economy are at their worst. So it is unsurprising to find many of them buying into the Japan argument.
“The U.S. faces a lost decade and we are already three years into this,” says David Ader, analyst at CRT Capital. “The U.S. has followed Japan with a housing collapse and a generic deleveraging that leaves us with banks still not willing to lend and businesses not expanding.”
He also thinks the U.S., like the case with Japan, has its own version of political weakness and demographic concerns, led by baby boomers facing retirement. He therefore thinks 10-year yields could go to 1.65-1.75 per cent should U.S. growth stall at 1 per cent.
But not all bond investors believe that the lurch lower can continue for much longer. Mr Davidson points to the fact that most traders have only known declining U.S. yields as they have consistently fallen over the past three decades. “We have been dumbfounded at the levels yields have reached. We don’t really believe the move but it is hard to fight it,” he adds.
Bond traders are expecting further policy initiatives from both central banks and governments. In particular, they anticipate the Federal Reserve will undertake further easing, possibly buying more longer-term Treasuries in order to narrow the gap to shorter-dated yields. But, with the 10-year note yield already below 2 per cent, the bond market has largely priced in such a move already.
Instead, some fret that the effectiveness of new stimulus measures is wearing off. “The perspective has changed, the debt stimulus of the past 30 years has met its conclusion, but we are still trying to squeeze the last remnants of toothpaste out of the tube,” says Mr Ablin.
The worries about a Japanisation of western markets remain acute. One reality seems inescapable whichever way investors vote. As Mr Matejka says: “It is very reasonable to believe that potential growth in the developed world will be lower than it was in the past 20 years. Therefore the rates of return on most asset classes should be lower.”