Inflation is a major driver of the long end of the yield curve. Investors typically don't lend money at rates at which there is a high likelihood that the proceeds, once repaid, will have less purchasing power than the initial money lent. That's the equivalent of buying high and selling low. So the fact that investors around the world are happy to lock their money away at rates which one can barely see with a magnifying glass is very telling.
But it gets worse. Investors are starting to lend money for free ... at 0% interest. Why would they do this? Simple, because they believe the alternative is worse. If you thought that just about every asset class was going to lose value in the foreseeable future, wouldn't you be happy with a 0% return? I would. Many other large scale investors would as well.
Before we go any further, you might be wondering ... If I'm going to earn nothing on my money, why would I bother lending it out? Why not just keep it under my mattress, in a safe, or in the bank? For individuals, this line of reasoning makes sense. Smaller accounts are FDIC insured, so the risk of losing that money is (in theory) very small. But it is not individual investors that purchase debt around the world, it is institutions and banks. And these entities are under a completely different set of constraints. A large institution can't find an insured place to keep a billion dollar deposit. What if the bank they store the money in collapses? Some institutions and banks are also mandated to hold high-grade government debt on their balance sheets. By purchasing government bonds yielding 0%, they are making a bold statement that rate of return is not a concern. Instead, the concern is protection of principal. Their actions are also implying that they believe (certain) government debt to be the absolute safest alternative in a world that is looking increasingly bleak.
Recently, the yield on 5-year Japanese Government Bonds (JGBs) hit zero for the first time ever, and the yield on the 10-year JGB reached a record low of 0.26%. Two-year JGBs are actually running below 0%, indicating investors are content to pay for monetary storage, as long as the principal remains safe.
Some of this is driven by policy, as both the ECB and Swiss National Bank have introduced negative interest rates on bank deposits. 0% certainly beats a negative percent, all else being equal. The Bank of Japan is also the dominant purchaser of its own bonds, as emergency stimulus measures continue in an attempt to stave off deflation.
[Listen to: Matthew Kerkhoff: Why QE Can’t Lead to Hyperinflation (Part 1) and (Part 2)]
But it's not just Japan. Yields on 5-year German bonds are at 0% and crossing into negative territory. The 5-year government bond in Finland fell below zero yesterday, as did the Swiss 7-year government bond. At the shorter end of the curve, 2-year yields are negative in Germany, France, the Netherlands, Belgium, Finland, Austria, Denmark and Switzerland. And the U.S., as discussed in previous remarks, is also seeing a flattening of the yield curve with investors bidding Treasury prices up and yields down.
The chart below shows the yield on the 30-year U.S. Treasury bond. During trading yesterday, this yield reached the lowest level EVER on an intraday basis. The chart only looks back 20 years, as this is the longest timeframe available from stockcharts.com. If we could see more history, we would find that long-term bond yields have been in a downtrend for over three decades.
Think about that for a moment. Yields have been falling for 30-years. It's no secret that lower rates stimulate the economy by spurring lending and investment. This means that every development in our economy over the past three decades, every boom and bust cycle, has occurred with the backdrop of falling interest rates providing a stimulatory effect.
That should make you wonder about the current predicament the global economy is in. These certainly are unique times. As I said earlier, inflation expectations are the major driver of this behavior. It's going to take a change in inflation expectations for things to begin reversing course, and inflation will not come without growth. With the tailwind of steadily falling interest rates no longer filling our economic sails, growth, it would seem, must come organically.
So if institutions and banks around the world are sending clear signals about global growth prospects ahead, should we heed their warning? In the words of a true economist ... perhaps. We've never seen global conditions as they are now, but that doesn't necessarily mean all is lost.
In fact, a look at other indicators of economic health in the U.S. sheds a much more positive light. Domestic small-business confidence in December reached the highest level in eight years. GDP has up-shifted in recent quarters, we continue to see massive gains in employment, and job openings — released yesterday by the Department of Labor — rose to the highest level since early 2001.
Most recently we saw "disappointing" retail sales data, which was largely responsible for yesterday’s sell-off, but even that has caveats. Overall, retail sales for December fell by 0.9%, largely as a result of cheaper gas prices. Excluding gasoline and auto sales, retail sales fell by 0.3%, a much more benign reading. I'll also caution that this report tends to be volatile and frequently sees significant revision.
Interestingly, a separate report by the National Retail Federation (NRF) paints a completely different picture. They reported that holiday sales for November and December rose 4%, an impressive gain. The discrepancy between the NRF's report and that of the Commerce Department is likely a function of monthly seasonal adjustments. What both reports agree on is that on an annual basis, retail sales continue to rise at a healthy pace.
The disparity in data and signals between the U.S. and global markets is leading to the choppy and erratic behavior in the U.S. equity markets. This is likely to continue until it becomes easier to discern an overall trend through all the noise.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
Related:
What Is the Yield Curve Telling Us About the Future?
