The U.S. has its own problem with negative-yielding bonds.
Unlike Germany, Japan and other parts of the world, the U.S. still offers its creditors positive returns. But last month, the so-called real yield — the bond’s nominal yield minus the rate of inflation — on 10-year Treasury Inflation-Protected Securities fell below zero, hitting the lowest level since just before President Donald J. Trump’s election in November 2016.
It’s not the first time the so-called real yield has turned negative. But it’s turned negative at the same time that inflation expectations have been sinking, sounding a double-whammy warning for Wall Street.
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“Real yields have just cratered and the pace of the decline is troubling,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “And with inflation expectations also falling, it shows the market is starting to price in a meaningful economic slowdown that will warrant a much more prolonged period of Fed rate cuts than just the midcycle easing the Fed had envisioned.”
Falling TIPS yields — “real” because they’re insulated from inflation risk — can be the product of economic or monetary policy stimulus that investors expect will lead to higher inflation down the road, but that’s not the case now. Regular Treasury yields, which are exposed to inflation risk, are also falling, and falling more rapidly than TIPS yields.
A narrowing gap between TIPS and regular Treasury yields — the breakeven inflation rate — signifies that TIPS investors expect inflation to add less to their return.
The 10-year TIPS yield fell to -0.12% last week, a drop of more than 130 basis points since November. The 10-year Treasury yield is about 1.5%, lower by more than 165 basis points over the same period.
The Federal Reserve cut rates by a quarter percentage point on July 31, with Chairman Jerome Powell characterizing it as a “midcycle adjustment” designed to guard against the possibility of a more serious slowdown in the face of rising global risks.
Rates futures traders are pricing in another quarter-point reduction at the Fed’s Sept. 17-18 meeting, and a total of more than 60 basis points of easing by year-end.
On Tuesday, the Institute for Supply Management’s purchasing managers index, a key manufacturing gauge, unexpectedly showed a contraction for the first time since 2016.
Following that, the 10-year breakeven inflation rate narrowed to 1.494%, a three-year low, as the 10-year nominal Treasury yield declined more than the 10-year TIPS yield.
“This sends quite a dire message,” said Mark Cabana, head of U.S. interest-rate strategy at Bank of America. Meanwhile, the Fed “seemingly doesn’t want to underwrite the trade war. So I struggle to see how they can become more proactive with policy given the risks it does face with regard to that perception.”
Not everyone is worried, though. To the extent that bond yields are low globally, and remain higher in the U.S. than elsewhere, the declines are a supply-demand phenomenon, said Greg Peters, head of multisector and strategy at PGIM Fixed Income.
“The dive in rates is more about the reach for yield and the U.S. being the only game in town,” said Mr. Peters, Morningstar Inc.’s fixed-income manager of the year in 2017 with three colleagues who run the Prudential Total Return Bond Fund. “Perhaps the real takeaway is that real yields’ natural resting place is 0% or even negative.”
U.S. bonds also have benefited from being a haven for investors worried about the U.S.-China trade war, Brexit and other upheavals.
While almost $17 trillion of the global stock of debt trades at nominal yields below zero, the figure jumps to $35.7 trillion when inflation is taken into account. It surged from $25 trillion in July, based on the Bloomberg Barclays Global Aggregate Bond Index.
In the U.S., more than $9 trillion of the nation’s government debt carries yields lower than the CPI rate. The figure was $4.2 trillion as recently as the first week of August.
All of that notwithstanding, the simultaneous declines in real yields and inflation expectations is troubling, said Nils Overdahl, a senior portfolio manager at New Century Advisors in Chevy Chase, Md.
“This is all definitely telling you there are long-run concerns about growth as well as the inflation outlook,” Mr. Overdahl said. “It does seem a bit overdone, but it’s probably a fool’s errand to try to call a bottom.”
