What bond markets say about trade war fears

Bond yields have tumbled alongside stocks this week, as investors move money into safe assets.

In a report released Thursday, CIBC Capital Markets chief economist Avery Shenfeld and head of North American rates strategy Ian Pollick said this is more than just a fixed income story: the market’s “love affair” with government debt says a lot about perceptions of where the market is headed.

U.S. 10-year Treasurys were yielding 2.26% when markets closed Wednesday. That’s down almost a full point since November and the lowest since September 2017, despite the Fed rate being 125 basis points higher. Canadian 10-years are at 1.55% and the German equivalent is in negative territory, the report said.

“Investors are taking money off the table after what has been a long bull market in equities, and parking money in what had been earlier judged to be unattractively low fixed income yields,” the report authors said.

The timing is not a coincidence since the risks of an escalated U.S.-China trade war are very difficult to quantify, they said.

Stocks rallied earlier this year when expectations for Fed rate hikes fell. “Now, the bond market’s message isn’t one of hope that dovish policy will extend the economic cycle; it’s a signpost of fear that the expansion will end.”

Shenfeld and Pollick said three elements explain the bond market: lowered expectations for inflation, a declining neutral interest rate and a worsening global outlook.

Lower inflation may not be a problem: it has allowed for lower interest rates and therefore reduced the risk of central banks causing a recession by hiking. The authors said that, like Fed chair Jerome Powell, they believe the pullback in U.S. price momentum is temporary, and that a return to 2% inflation would “put some upward pressure on long rates.”

Lower expectations for the neutral rate have also contributed to lower bond yields, the report said. In Canada, where the overnight rate of 1.75% is considered accommodative, “heavy household debt levels are countering any stimulus from interest rates where they are,” the authors said.

The problem with lower real neutral rates is that they allow less room for monetary policy to provide stimulus when needed through rate cuts.

“But even if rates are now near neutral, where the bond market has headed implies that we will need to shift to stimulative rates in the near future,” the report said, though probably not until next year.

Trade risk and the “flight to safety” is the most worrisome driver of the bond market rally, the authors said. However, they’re betting that the bond market is wrong and that trade tensions will ease, even if that won’t happen in a matter of weeks.

U.S. President Donald Trump will feel pressure to negotiate if stocks continue to fall, while pressure on China’s trade sector “can’t be papered over forever by Beijing monetary and fiscal stimulus,” they wrote.

Just restarting talks could reverse some of the recent bond market rally, the report said.

Summing up, the authors said investors should get used to low bond yields this cycle, due to low real neutral rates and a likely U.S. slowdown in 2020.

“But there are reasons to believe that today’s rally will at least partially reverse in the next couple of quarters if trade tensions cool, U.S. core inflation edges up, and most importantly, we takes steps towards avoiding a protracted all-out trade war,” they said.

Read the full CIBC report here.