Chief economist update: Bonds do the limbo rock

How low can they go?

Be afraid, be very afraid. A great number of investors are buying into the relative safety of long-term government bonds despite their dwindling yields, and in the case of the Japanese and Eurozone 10-year government bonds, negative yields - perversely paying interest to lend to the government.

Can't blame 'em. Disappointment over the Fed's non-commitment over further rate cuts - after it cut the fed funds rate by 25 bps to 2.25% at its July FOMC meeting - compounded by Trump's escalation trade tensions with Beijing and the depreciation of the Chinese yuan, raised market anxiety that the current global slowdown would morph into a recession.

This is underscored by the deepening inversion in the US yield curve, presaging a US recession in 12-18 months' time. The yield differential between the US 10-year Treasury bond had been negative since May this year. The current yield differential of minus 33 basis points compares with the positive 25 bps gap at the start of 2019.

Still below target inflation rates are providing impetus for continued decline in bond yields. If the relatively stronger economic growth in the past wasn't able to sustainably lift inflation to within central bank targets, what more now that growth around the world is decelerating.

Note: the People's Bank of China's inflation target is 3.0%; the Fed uses the PCE price index measure as its inflation gauge (1.4% in the year to June).

What is more is that US inflation expectations - the yield differential between 10-year US Treasuries and Treasury Inflation-Protected Securities (TIPS) has fallen to their lowest level in three years to 1.59% from a high of 1.94% in April this year.

The Reserve Bank of New Zealand (RBNZ), the Bank of Thailand (BOT) and the Reserve Bank of India's (RBI) surprise moves towards increased monetary policy accommodation on August 7 supports the bond markets' dim view over the prospects for economic growth and inflation.

Not only that, a Bloomberg report (dated July 23) shows that it's already preparing for the worst.

"In a paper presented to finance minister Grant Robertson in January and later released under the OIA, Treasury suggests three non-standard measures would be available to the bank," it states.

"The first is taking the OCR below zero" but not below negative 0.35%.

"The RBNZ could also conduct large scale purchases of either government or corporate bonds, known as quantitative easing" or "the targeted use of fiscal policy to support any unconventional monetary policy," it says.

Surely, other central banks are doing the same. But with bond yields (cost of government borrowing) this low, it's time for fiscal policy to lend a helping hand.

Read more: Grant RobertsonReserve Bank of IndiaReserve Bank of New Zealand
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