Friday, June 3, 2016

The Global Bond Market Bubble Moves Further Into Negative Territory

While the financial media is focused on the U.S. jobs reports, a much more important data point was released today. Fitch Ratings reported global government debt with negative interest rates rose from $9.9 trillion in April to $10.4 trillion entering the month of June. The total was "only" $7 trillion back in February, meaning more and more bonds are entering negative territory at a breathtaking pace.

The biggest contributors to the total pie of negative bonds came from Japan and Italy. Germany has negative yields out to 9.5 years, and Japan stretches out 14. Why would someone ever buy a bond when the yields are negative? Greed. 

Bonds rise in value when interest rates fall, and they fall in value when interest rates rise. You can think of the process like a seesaw.

While the average yield on Japanese government debt is -0.06%, investors that purchased these bonds at the start of the year have made 5.2% on their holdings. Why? The yields are falling, and it doesn't matter if that is happening in positive or negative territory. For example; if you hypothetically bought a bond at -0.1% and the rates fell to -0.2% the underlying principal value of your bond has risen.

Here is the juicy part; Larger investors can leverage their positions in these markets by buying government debt with borrowed money. If you are buying $100,000 worth of Japanese bonds and you only used $10,000 of your own money (you borrowed the remaining $90,000), then your returns are supercharged.

Investors are purchasing bonds with the sole intention of flipping them to the next buyer and locking in on the capital gains. They are not "investing" for the long term because this would mean they are holding an asset that guarantees an annual loss (negative bonds mean you pay the government to hold them).

The same process occurred during the real estate boom in 2006-2007. Investors would purchase properties knowing if they rented them out they would have negative monthly cash flow. This was of no concern because they "knew" they could just flip the properties to the next buyer in just a few months and lock in on the capital gains.

The problem will arrive when bonds yields stop falling and begin to reverse course. At that moment investors will be holding bonds with a negative yield that are simultaneously losing principal value every month. In addition to this pricing dilemma it should be noted that the entity borrowing the money, the Japanese government, is bankrupt. At some point that "small problem" will become a big one that is priced into the bond and currency markets.

While I have no possible way of knowing when this insanity will stop and bond prices will peak, I can assure you when they begin to reverse course it will not be a calm and orderly walk to the exits.  Asset prices (stocks, bonds and real estate) which have experienced the benefit of lower and lower borrowing costs every year for the past 35 years during the secular bond bull market, will now begin fighting against the current as the bond bear markets begins.

......As a quick side note, based on the global bond market movement today following the jobs report it is likely the total number of negative yielding negative bonds is now significantly higher than $10.4 trillion.

For more see: Moving Closer To The Next Global Minsky Moment

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