There’s been a lot of chatter recently about negative bond yields around the world. It’s happening in Japan and Europe and having a major impact on rates in the U.S.
The 10-year U.S. Treasury, while near historic lows, is still in positive yield territory — if you consider 1.49 percent much of a positive. We know mortgage interest rates generally move in the same direction as the yield on the 10-year Treasury. So this prolonged period of low rates is making money cheap for homebuyers and boosting business for lenders. For savers, this low-rate environment has been awful.
Wall Street has mixed opinions on what happens next. Some analysts believe Treasurys are overvalued and will soon reverse course, meaning prices will fall and yields (and mortgage rates) will rise. Others see reason to believe the high-price, low-yield environment continues.
My take? Yes, Treasurys are rich. However, I don’t see any real evidence domestically or globally to change the trajectory for now. Investors will continue to buy 10-year Treasurys, driving up the price and pushing yields (and mortgage rates) even lower. It would not surprise me to see yields drop to 1.25 percent (a new record low) in the months ahead.
I’ll explain my reasoning in a moment. But first let’s look a little closer at negative yields, why we’re dealing with them and how that impacts Treasurys and interest rates in the U.S.
A primer on bonds and yields
First, let’s make sure we all understand how government bonds function. Bonds, such as the U.S. Treasury note, are issued by a sovereign government to investors. The investor is paid an annual yield (similar to an interest payment) for holding the government-issued debt. Meanwhile, the price of the note (what the investor initially paid for the bond) fluctuates with the market. Price and yield move opposite each other. When bonds are in high demand and prices are high, yields drop. And vice-versa — low demand and sinking bond prices mean higher yields.
How do yields turn negative?
Negative yields are mostly artificial stimulus created by central banks trying to generate economic growth. When bonds have a negative yield, the bondholder is charged for holding the debt — the exact opposite of a normal lender-borrower relationship. The theory contends that by slashing interest rates below zero into negative territory, investors will choose not to hold government bonds and will instead put their money to work in other places. This gets money off the sidelines and into the economy to drive growth and accelerate inflation.
Negative yields today
This tactic has been used most recently by Japan. Other European countries are also trading at negative yields on their bonds.
But there’s a problem: It isn’t working very well. Instead of putting money to work in the real economy, investors have just looked for safe harbor elsewhere — mainly U.S. Treasurys. Foreign institutional investors don’t see growth opportunities in many places and are choosing to buy U.S. government debt. Just last week, for example, Japanese investors purchased $25 billion in U.S. Treasurys, according to Japan’s Ministry of Finance.
So what do we have?
Slow growth around the world prompted central banks to take drastic action, resulting in negative yields. But investors, seeing the same weak economies, just continued to look for safe investments in other bonds — U.S. Treasurys.
The result is slow growth globally and low yielding Treasurys. Some analysts and investors are beginning to say something’s gotta give. In fact, with such low U.S. yields, even Treasurys are in negative territory if foreign investors hedge for currency risk. So they predict U.S. Treasurys are now overpriced and will soon reverse course. Prices will fall. Yields will rise. Mortgage rates will increase.
I tend to disagree. There are few prospects of anything changing in the near term. Economic doldrums, major political votes (Brexit, Trump/Clinton) and instability (Turkey, ISIS, North Korea, etc.) are making investors more prone to seek safe haven. These same factors are also why I don’t expect the Federal Reserve to raise rates in September and more than likely stand pat at the end of the year, too. Sure, the U.S. economy is growing a little bit, and people have jobs, but I see no reason to believe investors will suddenly move out of Treasurys and into riskier investments.
We’re in a prolonged environment of low interest rates, exacerbated by negative yields and central bank policy that hasn’t delivered the kind of growth desired. The silver lining is apparent for mortgage bankers: Refinance will continue to make sense for millions of borrowers and cheap money will help offset the rising cost of homeownership.