Global markets are collapsing. The S&P 500 Index and the Dow dropped more than 3% each on Monday and Tuesday, creating a reverberating effect on markets outside the United States as well.
However, it’s not only equity markets that are crashing; treasury yields are also dropping. Even though the drop in stock prices can be attributed directly to the expectation of a slowdown in economic growth in the short term (the same as during past epidemics), treasury yields hitting record lows seems to be irrational in this situation.
On Tuesday, the 10-year yield fell to 1.3121%, breaching the lowest-ever reported level of 1.318% from back in July of 2016.
Source: Bloomberg
Even though the media might portray this decline as a sign of an upcoming recession or a period of negligible growth for America, this is far from the truth.
Lessons from economics theories
There is a negative correlation between treasury yields and the inflation rate of a country, which is the primary reason why regulators (including the Federal Open Market Committee) typically tweak the interest rate to keep inflation within a target range. The explanation for this is simple. When rates are low, consumers and corporations can borrow more, leading to a surge in business activities that eventually pushes inflation higher. On the other hand, the Fed tightens monetary policy and limits the money supply when it sees that prices are increasing at a much higher rate than is ideal.
Source: Federal Reserve
There is also a relationship between the unemployment rate and inflation. When an economy is growing, many jobs are created as companies expand both domestically and internationally. As a result, the unemployment level of a country tends to decline significantly. The opposite is true during periods of negative growth. This is depicted by the short-run Phillips curve.
Source: Lumen Learning
When both these concepts are combined, it becomes easy to realize that the decline in treasury yields to record lows seems illogical.
The current state of the U.S. economy
Despite the short-term macroeconomic and geopolitical headwinds, the U.S. economy still seems to be in firm footing. The signing of the Phase One trade deal with China in January renewed hopes of an acceleration of growth - at least until the COVID-19 virus broke out and shook investor confidence. The all-important unemployment rate is close to its 50-year low, which is a clear indication of the health of the world’s largest economy.
Source: GuruFocus
Going by the conclusions drawn in the previous segment of this analysis, I believe this should lead to a hike in the inflation rate of the country. This is exactly what happened in 2015.
Source: GuruFocus
Based on these factors, interest rates and yields in the U.S. can reasonably be expected to remain stable or rise in the future. The current environment is a complete contrast based on historical precedence, which makes it important to identify the underlying reasons behind this anomaly.
A couple of factors are behind the declining yields
One of the primary reasons behind crashing yields is the flight to quality in markets. This is not the first time such a phenomenon has occurred. In fact, whenever an external development has threatened the performance of capital markets, investors in all parts of the world were quick to seek the safety of assets such as gold, the U.S. dollar, the Japanese yen and American treasury securities, which are known as safe-haven investments. The fear that has crept into markets in the last few weeks has triggered massive demand for these assets (except for the yen that is struggling because of a slowdown in Japan’s economy).
According to data from Reuters, when SARS and Ebola broke out in 2002 and 2014, respectively, treasury yields in the United States declined.
| Year | Annual percentage change in the 10-year treasury securities |
| 2002 | -24.46% |
| 2014 | -28.62% |
| 2020 | -28.13% |
Source: Reuters
As evident from the data of the above table, yields declining during a global pandemic is not uncommon, which is why investors need not panic about a recession just yet. In 2003 and 2015 (the years following the outbreaks of SARS and Ebola), treasury yields gained once again as the markets returned to their normal state. Such an occurrence can be expected later this year as well, since the impact of COVID-19 will most likely last a few months at most.
The second reason behind the drop in yields is the very low interest rates in other developed regions of the world. Emerging markets naturally fall out of favor of investors when there’s a macroeconomic development posing a threat to the continued growth of the global economy. This leaves investors with no other choice but to look for income-generating securities issued by governments with acceptable credit ratings. The United States, many countries in the European region and Japan have historically been some of the favorite options. A quick look at the below table is sufficient to realize why investors are favoring U.S. treasuries today.
| Country | 10-year treasury yield |
| The United States of America | 1.36% |
| Canada | 1.21% |
| Germany | -0.51% |
| United Kingdom | 0.5% |
| France | -0.23% |
| Italy | 1.02% |
| Japan | -0.1% |
| Australia | 0.91% |
Source: Bloomberg
Because the U.S. government securities provide a better yield than many, if not all, strong economies in the world, there has been a surge in demand to buy these, which has eventually led to a decline in yields.
Under normal circumstances, treasury yields falling as dramatically as this would mean that a huge dent in inflation has either occurred or is about to happen. However, this time around, things are different. Any drop in the general price level will most likely prove to be temporary, as growth will resume once the spreading of the virus is curbed. According to IHS Markit, the second half of 2020 will be good for the world economy.
Conclusion
Yields declining to historic lows are all over media headlines, as this usually occurs when growth comes to a standstill and a recession is on the cards. However, I believe that this is a premature conclusion to draw considering the long-term outlook for global trade. There’s a possibility of another Fed rate cut later this year as well, which would help reignite some lost momentum.
John Fath, the managing partner at BTG Pactual Asset Management, told Bloomberg on Tuesday, “With yields below the Fed’s policy rate, it’s clear their hands are going to be forced by the market to cut rates if things don’t improve.”
As we have seen on numerous occasions, expansionary monetary policy decisions not only help consumers and corporations to borrow at lost costs, they also improve the sentiment of capital market investors, leading to a surge in demand for risky assets such as equities instead of income-bearing assets like treasuries. This is likely to happen in the third and fourth quarters of this year.
In conclusion, I think there's no reason for investors to panic solely because of the record-low yields.
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
- Investing in Biotech Stocks the Right Way During an Epidemic
- Interpreting Berkshire Hathaway's Buybacks
- Hedge Funds Are Buying Uber Despite Headwinds
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
Become a Premium Member to See This: (Free Trial):
