[The following is an excerpt from a commentary posted at TSI last week.]
One of the financial world’s most dangerous expressions is “this time is different”, because the expression is often used during investment bubbles as part of a rationalisation for extremely high market valuations. Such rationalisations involve citing a special set of present-day conditions that supposedly transforms a very high valuation by historical standards into a reasonable one. However, sometimes it actually is different in the sense that all long-term trends eventually end. Sometimes, what initially looks like another in a long line of price moves that run counter to an old secular trend turns out to be the start of a new secular trend in the opposite direction. We continue to believe that the current upward move in interest rates is different, in that it is part of a new secular advance as opposed to a reaction within an on-going secular decline. Here are two of the reasons:
The first and lesser important of the reasons is the price action, one aspect of which is the performance of the US 10-year T-Note yield. With reference to the following chart, note that:
a) The 2016 low for the 10-year yield was almost the same as the 2012 low, creating what appears to be a long-term double bottom or base.
b) The 10-year yield has broken above the top of a well-defined 30-year channel.
c) By moving decisively above 3.0% last week the 10-year yield did something it had not done since the start of its secular decline in the early-1980s: make a higher-high on a long-term basis.
The more important of the reasons to think that the secular interest-rate trend has changed is the evidence that the bond market’s performance from early-2014 to mid-2016 constituted a major blow-off. The blow-off and the resulting valuation extreme are not apparent in the US bond market, but they are very obvious in the euro-zone bond market.
In the euro-zone, most government debt securities with durations of 2 years or less rose in price to the point where they had negative yields to maturity, and some long-term bonds also ended up with negative yields. For example, the following chart shows that the yield on Germany’s 10-year government bond fell from around 2% in early-2014 to negative 0.25% in mid-2016.
Although yields have trended upward in the euro-zone since Q3-2016, German government debt securities with durations of 5 years or less still trade with negative yields to maturity. Even more remarkable considering that Italy’s new government is contemplating a partial debt default and a large increase in the budget deficit, Italy’s 2-year government bond yield moved out of negative territory only two weeks ago and is about 220 basis points below the equivalent US yield. To be more specific, you can buy a US 2-year Treasury note today and get paid about 2.5% per year or you can buy an Italian government 2-year note today and get paid about 0.3% per year.
Why would anyone lend money to the Italian government for 2 years at close to 0% today when there is a non-trivial chance of default during this period? Why would anyone have lent money to the Italian government or even to the more financially-sound European governments over the past three years at rates that guaranteed a nominal loss if the debt was held to maturity?
There are two reasons, the first being the weakness of the euro-zone banking system. The thinking is that you lock in a small loss by purchasing government bonds with negative yields to maturity, but in doing so you avoid the risk of a large or even total loss due to bank failure (assuming the alternative is to lend the money to a private bank). The main reason, however, is the ECB’s massive bond-buying program. This program was widely anticipated during 2014 and came into effect in early-2015.
With the ECB regularly hoovering-up large quantities of bonds almost regardless of price, speculators could pay ridiculously-high prices for bonds and be safe in the knowledge that they could offload their inventory to the ECB at an even higher price.
Negative interest rates and negative yields-to-maturity could not occur in a free market. It took the most aggressive central-bank interest-rate manipulation in history to bring about the situation that occurred in Europe over the past few years.
We don’t think it’s possible for the ECB to go further without completely destroying the euro-zone’s financial markets. Also, if it isn’t obvious already it should become obvious within the next couple of years that the aggressive bond-buying programs conducted by the ECB, the Fed and other central banks did not work the way they were advertised. Therefore, even if it were technically possible for the major central banks to go further down the interest-rate suppression path, they won’t be permitted to do so.
That’s why it’s a very good bet that the secular downward trend in interest rates is over.
About Steven Saville
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