With more than $10 trillion worth of global government bonds sporting negative yields, a U.S. 10-year Treasury yield at around 1.6% looks like a great deal.
But from a fundamental perspective, the current levels of Treasury yields make little sense, as they are completely disconnected from the fundamentals of the U.S. economy, said Deutsche Bank’s chief international economist, in a Friday note.
What’s more, hiding in the “gap” of this disconnect is the danger of a massive selloff in U.S. government bonds similar to the 2013 taper tantrum, during which yields skyrocketed as government bonds got hammered, said strategists at asset manager BlackRock, in a note earlier this week.
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The 10-year Treasury yield recently fell to a nearly four-year low, as investors flocked to U.S. government debt amid a global flight to quality fueled by central-bank stimulus, jitters about a potential U.K. exit from the European Union and widespread worries about slowing economic growth. Debt yields fall as prices rise and vice versa.
The government bond rally has brought many benchmark yields to record lows and even negative territory, most notably the 10-year German bond
known as the bund, which spent three sessions in negative territory this week for the first time in history.
“The risks are rising that we will have a clash between international forces pushing yields lower and domestic signs of inflation pushing yields higher,” said Torsten Slok, chief international economist at Deutsche Bank.
What’s more, the bigger the disconnect between yields and the economy, the sharper the potential correction, according to BlackRock’s analysis.
Traditionally, government bond yields rise when inflation and other economic fundamentals improve, leading investors to require more compensation to hold on to longer term securities.
Gross-domestic-product growth, which is the growth in the sum of a nation’s economy, is strongly correlated to interest rates—as GDP grows, yields climb.
But over the past six weeks, Slok says Treasury yields have become more and more disconnected from U.S. GDP growth, as the chart below shows.
Slok used the Atlanta Fed so-called GDPNow estimate, which is based on a forecasting model that provides a real-time “nowcast” of U.S. GDP, ahead of the official release.
On Friday, the GDPNow model showed a 2.8% GDP growth, the highest reading since late May, while the 10-year Treasury yield
was still hovering around its lowest level in nearly four years.
“The bottom line is, don’t confuse U.S. 10-year rates at [1.6%] as a sign that the US economy is not doing well. It is once again global forces that are the main driver of U.S. rates,” he said.
But what happens when fundamentals improve to such an extent that investors can’t ignore them anymore? BlackRock’s interest-rate strategists cautioned this week that the potential correction could be even more severe than the 2013 taper tantrum.
In May 2013, after the suggestion of an imminent reduction in bond purchases by then-Fed Chairman Ben Bernanke, panic spread in the bond market. The resulting selloff pushed the 10-year Treasury yield up by 140 basis points in just four months.
Currently, Treasury yields are at roughly the same levels seen before the taper tantrum, but “the risks in the fixed-income market have actually increased,” said BlackRock’s Rick Rieder and Bob Miller, who respectively head the firm’s global fixed income and multisector & rates teams.
Among the bigger risks is the size of global central-bank balance sheets, which have ballooned to $11.4 trillion from $8.3 trillion before the taper tantrum, while inflation in the U.S. has pushed higher than before the 2014 selloff.
Finally and most important, the percentage of negative-yielding bonds in the world has expanded from a scant 0.5% before the taper tantrum to 23% today, as this chart shows:
Amid all these increased risk factors, there is “widespread complacency about rates going higher,” which means that “fixed income may ultimately face similar headwinds to those witnessed in 2013,” the strategists concluded.