A lot has been made recently of the continued downward march of global bond yields and the affect that is having on economies and investment markets. Pension funds, for example, invest a large portion in bonds because they offer relative safety compared to equities, but increasingly the trade for safety over opportunity is becoming less of a guarantee and that has investors looking for alternatives.
In fact, the concern over falling bond yields is reaching a fever pitch as negative yields creep further into markets. BlackRock, in its report Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination, notes one-third of developed market government bonds and investment-grade bonds now have negative yields, and globally, bond yields are close to reaching their potential floor.
“The true madness is pension funds being forced to invest in assets, which will be guaranteed to lose, such as in the case of long-dated inflation-linked gilts at real yields of –3 percent,” says Mark Dowding, chief investment officer at BlueBay Asset Management, in a report by Bloomberg and Fortune. “It is financial vandalism and the government and central banks need to wake up to this.”
At the heart of the risk of lower interest rates is the potential for a domino effect. Rates underpin so much of the global economy, a wrong move on interest rates could ripple through countries and investment portfolios in ways both expected and unexpected.
Chief Investment Officer magazine reports that Mohamed El-Erian, chief economic adviser with Allianz, warns if negative rates come to America, it will break the system. “The U.S.’s financial institutions are set up to only handle positive rates,” El-Erian argued. Banks, retirement plans, and life insurers all depend on positive rates, he said. He criticized the European Central Bank for allowing negative rates to occur.
One question then becomes, how to keep rates from going negative while also supporting economies.
In its report, BlackRock summarizes the problem policy makers face and the opportunity infrastructure investors could reap as recession grows more likely:
- Unprecedented policies will be needed to respond to the next economic downturn. There is not enough monetary policy space to deal with the next downturn. Further support cannot rely on interest rates falling.
- Fiscal policy should play a greater role but is unlikely to be effective on its own. Fiscal policy can stimulate activity without relying on interest rates going lower — and globally there is a strong case for spending on infrastructure, education and renewable energy with the objective of elevating potential growth.
In other words, the reaction to past recessions we’ve grown accustomed to — cut interest rates aggressively and spend some — will not work this time around. And the next response to recession could include a new wrinkle — doing something about climate change.
Bloomberg opinion writer Brian Chappatta explains how these factors are playing out.
"On Aug. 8, just before 9 a.m. in New York, Reuters published a headline that blared ‘Germany mulls fiscal policy U-turn.’ According to an anonymous senior government official, Germany was considering abandoning its long-held balanced budget goal and instead was looking to fund an expensive climate-protection package with new debt.”
The prospect of government spending to spur climate policy and economic growth sent bond yields up. But the German government later dispelled the rumor. The episode is a good example of the type of market we are — high stakes and indecisive.
Chappatta, however, believes governments have a perfect opening to invest heavily in infrastructure while also being fiscally responsible.
“The problem, of course, is that more spending is usually framed as ‘bad’ while lowering taxes is ‘good,’ even though they both widen the budget deficit,” he writes. “In truth, both have appealing qualities — but only when applied properly.”
If done right, Chappatta writes that infrastructure spending could solve several problems, offering construction jobs that will help create new and improved infrastructure financed by government borrowing, which would create investor demand for safe assets — a virtuous cycle.
“Most crucially for the bond markets,” writes Chappatta, “it could counter easy monetary policy and some of the other forces leading to negative interest rates. This is a better solution than trying to rationalize guaranteed losses on bonds. The U.S., Germany and other sovereign nations have a clear green light to borrow. It’s up to elected officials to step on the gas.”
In such a program, private infrastructure capital would certainly have a role to play.
Those haunted by the 2007–2008 market can take comfort that some prognosticators expect the next downturn to be mild. Loomis Sayles reports in its latest macro strategy note, “indicators suggest the economy is in the downturn phase of a mini-cycle — a period of slower economic growth but not outright GDP decline. We believe manufacturing activity will pick up and the US economy will emerge from this mini-cycle without a traditional recession.”
