When navigating the choppy waters of 2016's stock market, the first thing an investor should do is look at the market for government bonds. Start outside the U.S. and note that short-term (two- and five-year) yields are negative in Japan, Belgium, France, Germany, The Netherlands and Sweden. Also, as has been widely reported, yields on the more liquid 10-year Japanese government bond (JGB) fell below zero on Tuesday, although that issue since has fallen slightly and is yielding a whopping 0.037% as of this writing.
This is the first time a 10-year sovereign issue has fallen below zero. Ever. Anywhere.
Does that scare you? Really, any time we start talking about "first time ever" events, it should raise investors' antennae.
What's happening? Well, in Japan, the 10-year JGB's fall below zero was presaged by the Bank of Japan's move to introduce negative overnight interest rates on Jan. 29. The European Central Bank first went negative on its overnight lending rate in June 2014 and actually cut that rate further into negative territory (-0.3%) on Dec. 3 of last year.
The overarching truth is that central bankers can control overnight lending rates, but the market controls long-term bond rates. The market is telling us that global growth has slowed dramatically and the current environment of deflation -- which became most visible in oil after OPEC's decision to hold production steady in Thanksgiving 2014 and since has spread to almost every other commodity -- is here to stay.
So, what's really happening is that yield curves around the world are flattening. Forget about the headline "Oh. My. God" 10-year bond yields -- below zero in Japan, at 0.22% in Germany and at 1.72% in the U.S. -- and focus on the term structure of interest rates.
A flattening of yield curves indicates the bond market sees less chance of future inflation, which is a product of lowered outlook for economic growth. The two go hand in hand and have for centuries.
So, let's go back two years and look at the slope of the medium-term yield curve -- the 2-10 year spreads -- for several relevant countries.
February 7, 2014
So, the inescapable conclusion is that global bond markets have priced in a much, much lower growth rate for developed economies. This is due in large part to the largest developing economy, China, not growing fast enough to sop up excess capacity of a myriad of goods that aren't consumed in the West.
The stock market is figuring that out in 2016, but the bond market has been telling us that for the past two years. We're in the midst of a global slowdown, and as equities are valued on growth -- versus bonds that are valued on total return, including return of capital -- portfolio managers are increasing their proportions of portfolios allocated to bonds, which of course comes at the expense of their stock allocations.
The first casualties of a flattening yield curve are always the banks. The natural bias for any lending institution is for a steeper yield curve as short-term liabilities (deposits) balance against long-term assets (loans). A quick look at the stock charts of Bank of America (BOA) or Deutsche Bank (DB) will show that the market understands the detrimental impact of flattening yield curves on banks' ability to earn appropriate returns on capital.
So, I believe the waters will remain choppy for the foreseeable future. The best way not to lose money on stocks is not to invest money in stocks. The financials and the momentum names have been hammered for the past few days, but really, I think investors should be following the fund managers and lightening up on overall exposure to equities.
Corporate bonds not only benefit from their capital-protective qualities, but also because they are priced against underlying benchmarks -- the respective 10-year sovereign notes -- that are increasing in value as investors seek safe-haven investments.