Diverse forces coalesce each minute to form the market pricing of a sovereign bond. American Treasury 10-year notes function as the world’s US dollar sovereign benchmark. The German 10-year (bund) benchmarks the euro, and the 10-year JGB represents Japan on this global scorecard. Right now, the US note has the highest yield at about 1.9% and the other two are around zero due to the negative interest-rate policy (NIRP) of their central banks.
This is the bond market’s tug of war. For the 23 NIRP countries, central banks prevail by administering interest rates. They have the ultimate power to do so.
In the United States, our central bank is trying to restore a positive interest-rate policy (PIRP) and gradually return to a more normal stance. Thus the US is at one end of the tug of war with our PIRP, while the others are pulling in the other direction with NIRP as the rest of the world observes and positions itself in the middle.
In normal times, the yield on the 10-year US Treasury note is influenced by federal deficits (which create Treasury notes), the inflation outlook (which alters the real buying power of those notes), the economic forces that raise or lower that inflation outlook, and international flows into and out of US Treasury securities. But these times we live and invest in are not normal.
Forces
In the US, several forces are at work to try to raise the interest rate. They are the Fed, which seeks a higher PIRP; some Services sector inflation; a very mild upward path in labor costs; and much reluctance on the part of investors to own bonds when interest rates are so low. These forces are slowly working in the direction of higher bond yields. They are tugging rates upward.
On the other end of the rope, foreign NIRP spreads to our shores and tugs our rates downward. Therein lies the bond investor’s dilemma. Do we look only at domestic US forces? Or do we factor in NIRP when forecasting US rates? We think the latter approach is correct, and we think NIRP is winning the tug of war.
All those countries and market agents caught in the middle between NIRP and American PIRP make allocation decisions daily. Do they place monies in NIRP-currency-denominated bonds, or in US Treasury notes? Or do they make other choices? Presently, the mix of those outcomes is leading to increased foreign allocations to our dollar and our government's debt. Thus foreign buyers raise our bond prices and cause our yields to fall, even as our domestic forces try to raise those yields.
We can estimate the strength of these foreign forces by looking at the spread between different benchmarks. Take the bund or JGB and compare each yield with the corresponding Treasury note. The spreads are widening even as the dollar strengthens.
By examining the last two years, we can guess that the 10-year Treasury yield might be 30 to 60 basis points higher today if there were no NIRP. We can make a guess that TIPS yields would be higher by tracking them as a spread to NIRP-country inflation-indexed bonds like those issued by France. And we see the spread widening as we examine shorter maturities such as the two-year notes.
Global Spreads
Wherever we look we see evidence of a downward force suppressing US yields because of the worldwide spread of NIRP. NIRP impacts all non-NIRP countries and exerts downward pressure on their rates. Thus NIRP is a global force.
We believe the domestic US upward force will gradually intensify. How much and how fast cannot be known. As the US economy and monetary policy evolve, the estimate of that upward force will be sharpened. Meanwhile the spread of NIRP continues, and its downward force also intensifies. This tug of war will continue for quite some time before a victor emerges.
So what is a US bond investor to do? We think it is time to evolve to a more defensive posture. Use hedging devices where they are appropriate. Use barbell structures. Think about types of bonds with characteristics that can reduce bond portfolio volatility. There are many options.
What is most important is to admit that we don't know the outcome of this tug of war and we cannot be precise about its timing. This is hard for investors to grasp. They want clarity in direction. They seek explanations of these strange NIRP-induced effects and the reactions to them.
But NIRP is new and is rapidly spreading its tentacles of market distortion. Two years ago it didn't exist. Now five currencies, 23 countries, and 24% of real total global output define the NIRP zone. And the NIRP zone is larger than the PIRP (US dollar) zone if you add the peripheral countries that are influenced by NIRP.
The tug of war is going to be with us for years. It is a remarkable development. It makes bond management more challenging than it has been in the five decades of my professional lifetime. Because of NIRP's power over US interest rates, our move to more defensive bond postures will be ongoing, at a gradual pace. That said, we will accelerate the pace if we see the tug of war moving in the direction of higher US rates prevailing over NIRP.
David R. Kotok, Chairman and Chief Investment Officer.