Life In A ‘Negative’ World

This morning, following a blockbuster of a June payrolls report, we flagged the disparity in how US Treasury yields should have behaved and how they actually behaved.

If you truly want to understand how distorted this market has become, have a look at the following chart going back to 1998:

As you can see, this a remarkable divergence and it should give you some idea about why Jeff Gundlach says you probably shouldn’t be buying US Treasurys right now. Here’s a look at the curve flattening since 2011:

We talked a bit this morning about what’s driving Treasury yields lower. In a nutshell, you’ve got a frozen Fed and rates that are still in positive territory versus negative yields on European and Japanese government bonds.

Will the aberration shown in the first chart above persist or is this a truly bad time to chase the rally in US debt as the bond king himself suggests? According to Goldman, the latter is probably the case. In a note out Thursday, the bank says US debt is “way too expensive.” Here’s the visual:

(Chart: Goldman)

According to Goldman’s model then, the 10Y has only been this expensive one other time since 1991.

How, you might ask, is this possible given the relatively positive economic data (“cleanest dirty shirt”) in the US? Here’s how Goldman explains it:

“The statistics we run suggest that US macro information has been pushing bond yields marginally up in recent months. These bond bearish domestic forces, however, have been completely overrun by global forces. Those emanating from Japan have been particularly dominant: The BoJ has achieved ‘financial dominance’ on the entire government yield curve through large-scale purchases of JGBs combined with negative policy rates. Since the latter were rolled out on 29 January, the 30-year JGB benchmark yield has fallen by around 100bp to close to zero, pulling down global yields with it.”

So again, a massive distortion. A gross misallocation of capital. And a very fragile state of affairs. Let’s look at a more poignant example:

(Chart: BofAML)

That’s right. A quarter of the global fixed income market has a negative yield. Think about that. One fourth of all the debt on the planet guarantees the lender a loss if held to maturity. And it’s a self-fulfilling prophecy. The lower yields go on government bonds, the more money investors will plow into investment grade corporate debt (IG). Of course that drives IG yields lower, which herds investors into high yield (HY) corporate bonds. That’s the dynamic behind the chart shown above.

For further perspective on just how out of hand this truly is, consider the following chart which depicts the projected share of the government bond market that central banks will eventually own:

(Chart: Goldman)

Note that Japan is set to own half of the entire market within two years.

So how does this all end? Well that’s the problem: no one knows because this has no historical precedent. But at the end of the day, US investors should keep in mind that stocks, bonds, gold, and oil can’t all continue to go up at the same time:

That defies logic. Of course so do negative interest rates.

Enjoy the weekend.

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