Markets send mixed signals as bund yields head to zero

Stocks are getting closer and closer to all-time highs, and bond yields, which move opposite to prices, are near their lows of the year.

That might normally lead to head-scratching, but both are the by-products of central bank easing, and strategists say U.S. long-end yields could keep moving lower even if the Fed does raise interest rates. Low yields sometimes signal flight to quality trading, the opposite of an environment that could send stocks to new highs.

Investors Thursday will be watching U.S. weekly jobless claims at 8:30 a.m., wholesale trade data at 10 a.m. and the 30-year bond auction at 1 p.m.. But they will also be watching the action in global bond markets, as the 10-year German Bund yield — at 0.04 percent Thursday — edges closer to zero and threatens to join its Japanese counterpart with negative yields.

Japan Economy, numbers
Tomohiro Ohsumi | Bloomberg | Getty Images

Treasury yields have been moving lower with global rates for weeks, and the 10-year yield is now at 1.67 - below the 1.70 percent level it's held above since February's market turbulence, when it hit its 2016 low of 1.66 percent. The S&P 500 on Wednesday closed six points higher at 2,119, just below 2,120 resistance and not far below the all-time May 2015 high of 2,132. Stock futures were lower Thursday morning.

U.S. yields are being dragged down as investors look for alternatives to the super-low yields in other parts of the world brought on by the activities of foreign central banks. This week, the European Central Bank expanded its buying of sovereign debt to include purchases of corporate bonds.

"The policy elephant on the other side of the globe is sitting on the rate structure, while all other market signals say rates should be higher. There's always been a sense that, throughout this recovery, that policy officials have been artificially affecting interest rates, divorcing them from the economic cycle," said James Paulsen, chief investment strategist at Wells Capital Management. "Commodities prices went up, bond yields didn't. Oil prices got better. Bond yields didn't go up. It seems like bond yields have no relation to anything right now. There's a really heavy override of policy officials holding rates down."

Boris Rjavinski, senior rate strategist at Wells Fargo Securities, said the big question from investors is how low can U.S. rates go. "There is really unrelenting demand for fixed income, particularly from Asia," said Rjavinski.

"You would think fundamentals would start to assert themselves at some point. Inflation is picking up in the U.S.," he said.

The $20 billion auction of reopened 10-year notes Wednesday drew good demand, and a record number of indirect bidders, at 73.6 percent. The reopening stopped at 1.702 percent yield. Indirect bidders can include foreign bidders as well as large U.S. asset managers.

"If it is foreign interest, it is very consistent with what I've been told by our clients in Asia. People literally say they can't put cash to work fast enough. There's a number of portfolios that are limited to conservative fixed income investments," he said. Compared to U.K. gilts, JGBs and Bunds, the yields in the U.S. would look good.

Strategists have been expecting the long end of the Treasury curve to stay depressed by the low yields in other parts of the world, but the short end could move higher when the Fed gets closer to raising rates. Rjavinski said investors he visited in Asia see one rate hike this year as already priced into the market.

"If you just look at fundamentals, it should probably be higher," he said of the 10-year yield. His year-end target is a yield of 2.02 percent.

Robert Tipp, chief investment officer and head of global bonds at Prudential Fixed Income, said the 10-year yield could stay in the 1.25 to 2.25 percent range for the next year and a half.

"It's a pretty damp squib world, and the U.S. is part of that," he said. He said it is unlikely the U.S. will join Europe and Japan with negative yields.

"The fact of the matter is, economies are not overheating. If economies were overheating and inflation was rising, there would be a belief this was an environment that would bring us to an end of negative yields, but all we're seeing is the world needs negative yields in order to have respectable growth," he said.

As for negative yields, he said the liquidity is helping to support the market. "I think though one area of danger is to the extent that negative yields are hurting the financial system," he said. "That could create some risk that could create strains in markets."

Some traders have said the move into Bunds was also the effect of concerns about Brexit, the U.K. vote on whether to leave the European Union. Tipp said that June 23 vote is the nearest risk to markets.

Paulsen said the bond markets appear more "manipulated" than ever by central banks. Telling is the fact that U.S. yields keep slipping, as if in a flight to quality, while corporate spreads are narrowing.

"The story might be if we make a run and breach a new high in stocks, will bonds finally respond?" he said.