Rather than head higher and pierce the 3 per cent level, as virtually everyone had expected at the start of the year, the yield on US 10-year government bonds has touched its lowest since October. And, at just 2.5 per cent, it is not the only interest rate to behave in such an unexpected way.
First, persistent concerns about the failure of American and European growth to “lift off” – including last week’s sluggish first-quarter eurozone data – have been amplified in recent weeks by spreading worries about “lowflation”. That is, inflation that is too low for too long and, as a result, risks pulling the rug from underneath inflationary expectations.
Perhaps nothing serves to signal such concerns more loudly than indications by the traditionally inflation-paranoid German Bundesbank that it would support the European Central Bank venturing deeper into unconventional monetary policy to counter lowflation.
Third, market positioning has turbocharged economic and policy factors. Few traders were ready for lower interest rates, let alone a flatter yield curve. As such, the recent yield moves have triggered market stops, forcing them to buy bonds to limit their mounting losses. Meanwhile, the lower the interest rates, the harder it has become for some long-term institutional investors to remain underweight bonds given the longer-dated nature of their liabilities.
In theory, there is little to worry about as lower interest rates should be self-correcting on all three counts. By reducing mortgage rates, they increase house affordability and, for existing homeowners, the incentive to refinance mortgages – both of which support home prices and housing activity. They also push investors out of bond holdings and into riskier assets.
Indeed, this is the main objective of the “unconventional policies” pursued by major central banks, in the hope that the resulting price surge in risky assets makes households and businesses feel better, encouraging greater consumption and higher investment (via energised “animal spirits”). Finally, offside traders’ positions get cleaned up as more are stopped out.
Having said that, the journey to low interest rates, and its volatility, warrant close monitoring. Sudden drops in interest rates raise concerns about the health of the global economy, leading to fundamentally-driven sell-offs in equities and other risky assets – a worry that is amplified by the extent to which the earlier equity rally had decoupled prices from more economic sluggish conditions.