Worldwide, bond yields are tumbling swiftly on the heels of major shifts in central bank policy in the US and the EU. Last month we witnessed the collapse of bond yields, especially in those countries already experiencing negative yields. Overall global debt trading with negative yields soared, reaching a level of $12 trillion. While German and Japanese government debt have traded for several years in negative territory, that club has expanded to over 15 countries, including all the major countries in the EU. Europe is now expected to follow in the path of Japan into a permanent world of very low inflation, if not outright deflation, and meager growth.  

Bond investors have taken heed from more than a decade’s experience in Japan and Germany of extremely low rates. Japan has been buying government debt and selective equities under a broad program of quantitative easing for nearly two decades without any inflationary impact. It seems the longer investors observe rates fall in Japan the more disinflation takes hold. Germany has been at the forefront of European austerity programs and as a result has had little need to issue more bonds, while at the same time the market has been clamouring for more safe-haven bunds. And, as the EU remains in a slump, Italian and French bonds have also dipped below zero.

Despite the efforts of the European Central Bank (ECB) to encourage commercial banks to expand lending, these banks have been diverting excess reserves into the safety of government bonds, thus driving yields even lower. This type of behaviour becomes a self-fulling prophecy as banks withhold lending which in turn slows economic growth, ultimately contributing to lower yields and further discouraging lending. Zombie banks have existed in Japan for many years, and it seems as if European banks are now adopting a similar nature. 

But in North America interest rates are positive. So, should we be concerned about what happens in Europe and Japan? Are we living in separate worlds?

The first clue to answering these questions is found in the shape of the yield curve. We hear a lot about the yield curve inversion--- where long term rates are below short rates----- and how that is a harbinger of a recession in the near term. The U.S. and Canadian benchmark bond yields are below their key policy rates. The US 10-year bond closed at 2.05% whereas the Fed funds rate sits at 2.5%. Canadian 10-year bond is trading at 1.55% and the Bank of Canada policy rate is set at 1.75%. North American central banks cannot escape the downward pressure from debt markets in the EU and Japan. The Fed has given every indication it will likely cut rates, possibly at its meeting later this month. The Bank of Canada has been quite adamant that it is not in a rate cutting mood, and so far, the Governor has remained remarkably silent on the matter. Nonetheless, he will be under pressure to lower rates, following cuts in the US. 

While the stock market players may cheer the news that long-term interest are falling, they will in time realize that the collapse in yields should be interpreted that the global economy is in trouble. In an earlier blog , I outlined how low interest rates signify that bank lending will be more stringent and that growth will slow considerably. Moreover, the central banks do not have much room to lower their bank rates before they hit zero, thus any central bank intervention will not be successful in preventing a world from sliding into recession. This process of lowering long term rates will likely continue in North America. After all, rates here are still considerably above those in Europe and Japan. and any money flowing in from those areas will only bid up bond prices (dropping yields further) here at home. As both the Fed and the Bank of Canada meet this month, just how low rates can go will be likely be an important topic of discussion.

See also here.