Global Government Bond Yields Are Plummeting

The latest movements in markets are starting to be in sync with a slow growth economy. This makes sense as the blue-chip GDP forecast has been decelerating quickly. The global trend in declining bond yields can be see below. The range the U.S. ten-year bond was in for the beginning of the year has been broken to the downside. Because yields were at record lows last summer, many investors assumed that was the bottom, but that assumption may be wrong. The bond yields had increased since the summer because an uptick of inflation due to rising oil prices, some improvement in U.S. survey data, and an increase in Chinese credit growth.

The amount of credit sloshing around in the Chinese economy has been increasing lately. Aggregate financing increased $308 billion last month. As you can see from the chart below the total Chinese social financing in Q1 was equivalent to slightly above $1 trillion. When the credit cycle reverses globally, this trend toward increasing credit in China will also fall flat.

On Tuesday, the Dow was down further than the other indices because Goldman Sachs had an uncharacteristic earnings miss. The Dow fell 0.55% while the Russell 2000 was pushed to the positive side, closing up 0.05%. Goldman Sachs beats earnings 90% of the time, but it missed EPS expectations by 16 cents causing the stock to fall 4.72%. The stock is now down almost 15% from its all-time closing high on March 1^st. The banks which reported good earnings have seen their stocks fall, so it’s not surprising to see Goldman Sachs stock crater this much. Goldman underperformed the other banks partially because it is an investment bank which is different from a traditional commercial bank. One example of this is the net interest income category where Bank of America had a 5% increase year over year while Goldman Sachs had a 42% decrease.

One of the reasons bank stocks have declined besides the recent pull back in rate hike estimates due to weak economic reports and the pause in hikes when the balance sheet starts to unwind is the uptick in delinquencies. While the recovery has been lumpy, the rate of year over year delinquency declines has steadily fallen. The deceleration has led to delinquencies starting to increase again like they did in the previous two cycles. Be careful in reviewing the chart below because the left-hand scale is inverted to show the correlation between the S&P 500’s year over year returns and the average 30-day delinquencies of major credit providers.

As I said, the banks are being negatively impacted by the decline in the forecasted number of rate hikes because of weakening growth expectations and base effect of oil prices stopping inflation from moving higher. As you can see from the chart below, the March core CPI (which doesn’t include energy and food inflation) decelerated to 2%. The Trump-flation and increase in Chinese credit have boosted liquidity causing the core CPI to stay above the Fed’s 2% inflation target since November 2015. The decline in global bond yields is signaling that inflation rate won’t stay above 2% for much longer. The Personal Consumption Expenditure index has been below 2% since May 2012 as you can see from the green bars below.

In a few posts prior to the Fed announcing it will go through with the unwind of the balance sheet this year, I had assumed that long-term interest rates would rise when the bonds were allowed to expire off the balance sheet without being rolled over. I didn’t consider it a prediction as the law of supply of demand is unwavering. However, the unwinding of the Fed’s balance sheet and the tapering by the European Central Bank and the Bank of Japan has led to this recent global collapse in yields. Just like the economic data points like the unemployment rate and inflation, the Fed doesn’t have as much control over the long-term bond market as it expected.

Unlike the Fed, I can simply say my assumption was incorrect. The can’t do that because it would cause journalists to ask if this caused it to change its guidance. If the Fed changes its mind on the effect of the unwind of its balance sheet, it would be expected that it would change its plans. The one aspect the Fed did get right is it said because it has no experience with an unwind, it doesn’t know what the economic effects will be. That was in the earlier statement this year which I mistakenly interpreted to mean the Fed was delaying the unwind until mid-2018.

Besides the fact that the announcement of the unwinding of the Fed’s balance sheet has spurred a flight to safety trade, the small size of the amount of bonds which are going to expire this year makes it understandable why the market didn’t react to the increased supply. Only $153 billion of the Fed’s $4.250 trillion in securities owned outright expire this year. It’s possible the bond market will react suddenly when it happens, but that’s unlikely. The ECB tapered its bond buying program by 20 billion euros in April and the rates of the German and Italian ten-year bonds have fallen. The chart below shows when the bonds on the Fed’s balance sheet mature. There’s $2.4 trillion in bonds which don’t expire until over ten years from now. Those bonds may not be allowed to mature because some are suggesting the Fed’s balance sheet should hold some securities. It held about $800 billion in assets before the crisis. Ben Bernanke says the Fed’s balance sheet should stay at $2.5 trillion.

Conclusion

The flight to safety trade is on in the bond market as yields are falling at the behest of the projected decline in global central banks’ balance sheets. One reason for this is only $153 billion in the Fed’s bonds mature this year. Goldman Sachs had a bad quarter because of weakness in its business opposed to macro trends, but the commercial banks are about to start to show weakness as default rates are increasing.