Tread Cautiously Amid Potentially Negative Treasury Yields

For various global central banks, the battle against poor economic growth and the absence of inflation is only getting tougher, encouraging them to adopt even more aggressive Negative Interest Rate Policy (NIRP), such as in Japan and the Eurozone. As more and more sovereign debt with ‘safe-haven’ status yields negative returns, the demand for US Treasuries has been mounting and pushing yields lower, with the 10yr currently trading at around 1.51% (at time of writing). This coupled with rising economic concerns amid a worsening US-China trade war has also simultaneously boosted demand for 10yr Treasuries, helping push the yield even lower. While some investors have become skeptical of the sustainability of the rally, others remain strongly bullish as economic conditions worsen and US monetary policy conditions inevitably need to become looser. In fact, there are rising chances of Treasury yields turning negative amid global bond-market and economic developments. Nevertheless, investing in negative-yielding debt does come with heightened risks for fixed-income investors.

Why do investors invest in negative-yielding debt?

Any rational investor would question the rationale behind allocating capital towards debt-instruments where the lender pays the borrower. And yet, negative-yielding government bonds, such as those of Japan, continue to attract investor capital. Firstly, the most obvious reason why investors continue to buy such debt securities is to profit from bond price appreciations as yields continue to sink. Moreover, longer duration bonds tend to witness the greatest levels of price appreciation amid falling interest rates. Note that bond prices roughly witness a 1% rise for each year of respective duration, in response to every 1% decline in interest rates. Therefore investors continue to pile into longer-duration bonds as capital gains strongly outweigh the sliding negative yields. Thus this emboldens the bullish case for Treasuries even if yields plunge into negative territory.

Furthermore, another factor to take into consideration is the cost of hedging for US investors. For instance, while various European 10yr government bonds are yielding negative returns, US investors are still able to indirectly earn a positive yield due to the mechanisms of forex hedging. Keep in mind that forex hedges are based on the relation between the short-term interest rates of the two respective economic regions. Therefore, given that US interest rates (2%-2.25%) are higher than in the Eurozone (Deposit facility rate at -0.40%), US investors earn income when hedging against the Euro. Hence adding this income to the negative yield of the bond actually results in a positive yield return, thereby allowing them to benefit from both capital gains and a positive yield. Though with the Fed cutting rates as well, this strategy will be undermined going forward.

Treasuries are becoming increasingly vulnerable

As Treasuries continue to rally in response to sinking yields, potentially even into negative territory, the bond market could turn into a bubble that would be vulnerable to even the slightest hawkish economic development, at which point investor demand should diminish as the risks are not worth taking anymore. While longer duration bonds may offer attractive capital gains that effectively outweigh negative yields amid deteriorating economic conditions/ loosening monetary policies, keep in mind that these securities are also most vulnerable to rising yields. Therefore, if for instance at some point in the future we witness signs of improving global trade relations/ rebound in the manufacturing sector, then the long duration bonds could sell-off sharply. Furthermore, while such capital losses would already be burdensome, it could potentially be worsened by negative yields, whereby on top of the capital losses, investors need to pay out yields to the borrowers that are no longer being outweighed/ compensated for by bond price gains.

Therefore, while at present the economic outlook seems to be worsening, making it a favorable time to be bullish on Treasuries, investors should take into consideration the heightened risks that come with allocating capital to increasingly expensive fixed-income securities with potentially negative yields going forward. Given the unprecedented nature of negative yields, the eventual reversal of the bond rally will be catastrophic for Treasury bulls, relative to previous downturns in Treasury prices.

As the safe-haven status of Treasuries is undermined by potential negative yields, it emboldens gold’s appeal during times of uncertainty. In a previous article, I evaluated the bullish case for gold, arguing that various factors are turning favorable for a long-term rally in the precious metal. While gold’s naysayers find the commodity unappealing due to not producing any yield; no yield is certainly better than negative yields. Therefore, instead of piling into negative-yielding expensive Treasuries, I would advise allocating capital to gold to weather times of economic uncertainty.

Bottom Line

The chances of US Treasuries yielding negative returns at some point in the future are rising. Bullish investors continue to pile into the safe-haven asset amid expectations of worsening economic conditions and easier monetary policies ahead. However, as this rally spirals into uncharted and extreme territory, it becomes increasingly vulnerable to potential positive economic developments in the future, in which case investors would face magnified losses as price declines would be coupled with potentially unprecedented negative yields. Thus, speculating on rising Treasury prices amid negative yields would appear irrational given the presence of an appealing alternative safe-haven asset, gold. Therefore, while the rally in Treasuries may certainly not be over yet, investors should take the precious metal into consideration as well when building defensive strategies, because unlike bonds, any unfavorable reversal in gold rallies will not be aggravated by negative yields.