Markets had one of the worst starts on record in the first 2 months of 2016. A collapse in crude oil prices, lead to concerns of high yield exposure, but more importantly lead to negative sentiment regarding growth. In this post I will be showing some of the drivers that are sending yields lower.
The US reported a very weak 4th quarter GDP number, oil prices were below $40 and the markets were asking themselves whether the oil collapse could be due to very weak global demand growth, instead of just robust supply. US sovereign debt rallied as equity markets saw declines led by crude shares in mid-January as oil touched $26. The US 10-year yield saw a decline from 2.3% to 1.65% in a short 1-2 month time frame. This lead to a broader market sell-off, that also led to sell-offs in popular technology names and financials, which saw troubles spread from DB and Credit Suisse.
As this seemed like a broad global market sell-off, I decided to look at aggregated data from the developed world. I combined all G-7 country yields to create an aggregated bond yield to better illustrate the global move towards low and in some cases negative yields for sovereign debt.
Longer dated yields are highly dependent on growth expectations and subsequently inflation expectations, which usually go hand-in-hand with growth. Above, I correlated my G-7 10-year bond yield to oil price. We can clearly see a strong relationship between lower oil prices and bond yields, likely from a combination of safe-haven demand as falling oil prices have lead to lower equity markets in 2015 and 2016 and significantly lower inflation expectation as oil is an important input cost for almost every activity in the modern world.
Global growth expectations also have a significant impact on sentiment and expected inflation. I combined estimates for 2016 and 2017 GDP growth and averaged between the G-7 Countries.We can clearly see below how these declines move in tandem with one another. Global GDP growth has also been hammered by fears of a slowdown of the US and China, which together make up about 60-70% of global GDP growth.
Going further, I broke down the change in E2016 GDP for each of the G-7 countries and compared it to each of their 10-year bond yields. There is a clear positive relationship between growth and bond yields. Of course the fixed income market is multi-faceted and there are a slew of other factors affecting yields. For example, while growth projections for the UK and France have declined or stagnated, bond yields have actually risen significantly in relative terms. This can be likely be traced to other factors such as possible “Brexit” fears, while France has become a laggard titan of financial stagnation in the Eurozone with governmental finance continuing to deteriorate.
The move to typical safe havens in the US and Japan has seen bond yields drop in the these countries significantly. As the 10-year yield is used as a risk-free rate for corporate debt, it would seem logical to assume that lower yields would be beneficial – leading to lower funding costs for large firms. Illustrated below, the spread between investment grade bonds has widened about 1% since the middle of 2014, while the US 10-year yield has only declined about 80 bps. This effectively means firms will experience marginally higher borrowing costs instead as investors seek safe havens.
Concurrently, junk debt saw an increase of 5%, which is largely due to a large amount of energy company debt which makes up about 20% of the index.
The lower yields seen in the bond market in recent months have been largely due to reduced global growth expectations, led by the US and China, as well as lower oil prices, which have pushed global inflation expectations lower. This environment will likely continue as long as:
- Growth in the United States remains uncertain
- Chinese debt and growth concerns persist
- The oil market glut continues and prices remain low
While we may not be entering a global recession/depression scenario, there are clear signs that market participants are positioning defensively for turbulence ahead. I will be covering more of these concerns in my next post.