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In July 2016, bond yields across the globe hit what I thought would prove to be their nadir.
It seems that I was wrong.
The yield on ten-year German bunds has, almost literally as I type this, slid below the depths it last plumbed in the wake of the Brexit vote.
So what’s going on?
Germany is particularly vulnerable to a global trade crash
In July 2016, the ten-year German bund yield fell to negative 0.19%. In other words, investors were paying the German government for the privilege of lending to it (to be fair, investors in Swiss debt were paying a lot more).
For a long time, it looked as though that was the low. Investors didn’t like the idea of Brexit, but they were growing less concerned about a blow-up in the eurozone, and the US – while distracted by bad-tempered electioneering – was doing well economically.
And yet, this morning, we’re back where we were in July 2016. In fact, we’re even lower. German bund yields are at their lowest level since at least 1990, according to Bloomberg. The Daily Telegraph goes a little further with a headline that says they haven’t been this low in 700 years, although I’m not entirely sure where that analysis stems from.
Anyway, the point is – they’re at fresh record lows. That’s not a good sign, however you frame it.
So what’s going on?
There are elements of this story that are unique to Germany and the eurozone. Bond yields in the US have fallen too, but they’re not yet back at record lows. Let’s look at those first.
Firstly, remember that the European Central Bank (ECB) is maintaining current levels of quantitative easing (QE). In other words, while it’s not growing its balance sheet, it’s not shrinking it either. That means that when a bond matures, it needs to use the proceeds to buy another to replace it.
This, notes Marcus Ashworth on Bloomberg, is “a key factor in why German ten-year benchmark bonds have negative yields again… When yields are this minuscule, even the ECB’s reinvestment of the money from maturing bonds… has a disproportionate effect on prices. It means there’s little left to satisfy demand once the central bank has done its buying.”
In other words, there’s lots of demand and supply – even although there’s plenty of it, it’s not as though eurozone countries aren’t issuing debt – can’t keep up.
Secondly, Germany is particularly vulnerable to protectionism and its effect on global trade. One reason the record has been hit again this morning is because of the news that Donald Trump has just slapped a 5% tariff on all Mexican imports.
The move will start from 10 June. Trump says he wants Mexico to take more action to stem illegal immigration. He also says that the tariffs will climb by 5% a month until 1 October, when they’ll be at 25%.
This introduces a new level of uncertainty into trade. The US and Mexico seemed to have been getting along better as recently as earlier this month, after the US dropped tariffs on steel and aluminium products from Mexico and Canada, after renegotiating the NAFTA trade pact.
Markets had rather started to assume that maybe Trump was concentrating on dealing with China first. But if he can multitask – if he can just wake up and decide to slap tariffs on Mexico for a non-trade related reason – then that just reawakens all of those fears about turning his sights on car manufacturing in Europe, for example.
In short, a more protectionist world hits export-reliant economies hardest in the first instance. So this is particularly bad news for Germany (although it’s pretty bad all round as far as I can see). Indeed, it’s bad for the eurozone in general.
So there are elements of this that are eurozone specific.
How a deflation scare could be followed by an inflation shock
However, while it would be nice to brush it off as a local disturbance, that’s just not possible.
Yields might not be at record lows in the US, but they have fallen hard in the last few months. Same goes for the UK. So what does it mean?
Put simply, investors are scared that there’s going to be a recession. As a result, they’re betting that interest rates will have to fall or money printing will have to restart. Therefore, why not own bonds? After all, equities won’t do much for your in a recession as corporate earnings collapse.
You can see the logic. The risk of a protectionist spiral is starting to look quite real. The current expansion is long in the tooth – they might not die of old age, but someone usually finds a way to kill them eventually. A recession is only a matter of time. That’s how cycles work.
And yet, I’m still not entirely convinced that it makes sense for bond yields to be sitting where they are.
Here’s a worrying thought. We all agree that populations are feeling restive. They’re not satisfied with the quality of leadership being shown by our politicians. They want change. They are happy to at least contemplate radical ideas and policies.
This is happening at a time of full or near-full employment around the globe. So it’s happening at a time where most people’s individual economic circumstances are acceptable, and full-on economic hardship is limited to a relative minority.
What happens if we get a recession, and unemployment starts to rise? Does protectionism become more, or less, popular? Do demands for “money printing for the people” grow louder or drop in volume?
It’s pretty obvious. And the thing is, both protectionism and money printing for the people (rather than financial institutions), are inflationary.
We’ve been so long without inflation that we seem to have forgotten that a recession can go hand in hand with rising prices – it’s called stagflation.
In short, I can see why bond yields are sliding, and I increasingly think that markets are right to be worried. But I can see a deflationary scare being followed rapidly by an inflationary wake-up call.
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