The payout on short-term and long-term bonds is incredibly low among most developed economies across the globe, and many economists are predicting this drop could be signaling a coming recession.
When citizens buy government bonds, they are purchasing government debt with the promise of a return on their investment. The yield is the “interest rate the US government pays to borrow money for different lengths of time.” The yield influences how “the interest rates individuals and businesses pay to borrow money to buy real estate, vehicles and equipment.” Typically, the higher the yield, the better the outlook on the economy, Bloomberg reported.
Global bond markets are largely floundering. Bond yields are incredibly low in Switzerland, Germany, England, and Japan. Japan is actually experiencing negative interest rates. The Federal Reserve Bank of the United States is keeping interest rates low as well.
The yield curve, which shows the maturity difference between long-term and short-term bonds, has been relatively flat, reports Business Insider. Tom Fitzpatrick, leader of the Citi’s Technicals team, said that the levels between US two-year bonds and five-year bonds are very flat and that “the current level of about 35 basis points is the line in the sand.”
Research finds that the yield curve recently inverted, and the last two times that happened, it signaled a negative market event and that “a recession is ahead,” reports Business Insider.
Research from Citi shows that the three most recent breakdowns of that level produced a move lower to at least 11 basis points. And the yield curve eventually inverted, though in the case of the 1994 breakdown an inversion didn't occur until the end of 1997.
Financial Crisis
George Soros warned in January that the bond market in China could be a signal of a repeat of the 2008 financial crisis, according to MarketWatch. Jeffrey Gundlach, founder of DoubleLine Capital, warned that the US “bond market could implode” with widening in maturities since 2014 which could threaten to trigger the next financial crisis.
Mohamed El-Erian, Allianz’s chief economic adviser, said that normally the conditions would signal a recession is ahead. El-Erian notes that what is actually pulling down the yield curve “has less to do with the US and has more to do with Europe,” according to BI.
Deutsche Bank analysts, however, say that the current state of the yield curve “implies a 60% chance of a recession in the next year based on historical patterns,” reports the Wall Street Journal. Long-term interest rates in the US hit a record 227-year low in early July.
Fixed-Income Market
Theoretically, the impact on the fixed-income market is primarily based on two major prepositions (apart from other considerations), the ‘coupon effect’ and the ‘maturity effect’.
In theoretical terms, an interest rate hike negatively impacts the bond market, as the rate at which the series of cash flows are discounted increased, which in turn lowers the bond’s price. Thus some form of weakening in the fixed income market is warranted once the US' Federal Reserve Bank opts for such a move.
That said, there is more to that and the interesting part is the magnitude of the impact. Looking at the ‘coupon effect’, the higher the coupon the lower the impact. The reasoning is based on the fact that as interest rates increase, investors will fetch higher returns and sell their low coupon holdings and shift towards higher return positions. On the contrary, the magnitude on low coupon issues will be larger than the former.
Likewise, looking at the ‘maturity effect’, the longer the maturity the larger the negative impact on price. Here the reasoning is also based on the fact that longer dated issues are more prone to possible economic cycle risks. The ultimate result is the downward pressure on price, primarily also on lower coupon issues, as investors are not getting paid in terms of risk-adjusted returns.
To sum-up, theoretically higher coupon bonds with a medium term duration should be less impacted, while lower coupon bonds with a longer duration will be hit remarkably.
