Risks and rewards as yields fall

In a world of negative-yielding government bonds, a Federal Reserve in easing mode might have investors reconsidering U.S. Treasurys.

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The Fed cut its benchmark rate last month by 25 basis points in an effort to counter global trade tensions and persistent low inflation, and easing isn’t expected to end there. Markets put the odds of another Fed rate cut, in September, at almost 79%.

Ahead of the Fed’s most recent decision, Andrew Kronschnabel, head of investment grade credit at MetLife Investment Management in Philadelphia, said his firm forecasts the Fed to cut a total of 50 basis points this year. As a result of those cuts, “Our forecast for 10-year Treasurys is to end 2019 at 2.15%, and end 2020 at 2.45%,” Kronschnabel said in a July 24 interview.

If rates remain at these relatively low levels or go lower, he said emerging markets sovereign-dollar debt and local debt should continue to attract inflows as their nominal and real rates offer more attractive yields relative to U.S. Treasurys.

More generally, inflows to non-U.S. sovereigns will also be attractive at lower yields, he said. Further, the technical outlook for non-U.S. sovereigns remains supportive because their net supply is low, he said.

Since the Fed’s cut on July 31, yields on the 10-year U.S. Treasury have dropped from above 2% to below 1.7%.

Kronschnabel’s team gains exposure to non-U.S. sovereigns via Gulf Cooperation Council  countries. The team adds idiosyncratic risk in places like Ukraine, or local currency risk in countries like Brazil, where IMF backing or domestic reform agendas control shorter-term asset price performance.

Challenges for international sovereigns and risk assets

The caveat to Kronschnabel’s recommendations is slower economic growth.

“If global growth continues to deteriorate past the point of a typical mid-cycle slowdown, then we anticipate risk assets, especially emerging markets and non-U.S. sovereigns, to perform poorly,” said Kronschnabel.

To evaluate global growth, “we’re watching for bottoming signs in Europe, which we have yet to see,” he said, as well as the market impact of China’s fiscal and monetary stimulus, which has yet to take hold.

He added that global trade, which remains uncertain, will also impact growth.

The sheer amount of negative-yielding debt creates unintended consequences, he said.

“Currently, there is over $13 trillion of negative yielding debt [and] nearly all of it is sovereign,” Kronschnabel said. “The trend is accelerating, and the overall yield of that debt is moving more deeply negative, currently −0.32% in aggregate.”

In fact, since Kronschnabel was interviewed, Bloomberg Barclays Global Negative Yielding Debt Index closed at more than $15 trillion.

The list of countries with negative yields is long: “Swiss, German, Dutch, French, Swedish and Japanese 10-year governments are all in negative territory,” Kronschnabel noted, with other central banks including India, South Korea and China recently easing. The Swiss curve is below zero to 50-years. “Even Greek debt yields less than U.S. 10-year Treasurys,” he said.

As investors are forced to take on more risk, valuations become inflated for commodities, credit assets and equities. Banks are also affected.

“When the price of money is distorted so massively, bank profitability is pressured,” Kronschnabel said. “Not one European bank is currently earning its cost of equity, and share prices have reacted.”

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