(Bloomberg opinion) – It is often said that inflation is the scarecrow of bond traders. In fact, the acceleration of price growth decreases the value of each fixed interest payment over the years. Investors would be better off buying assets that go up with prices, like real estate or stocks, in theory.
Bond traders are learning this week that the prospect of deflation can be just as painful.
The 10-year US Treasury benchmark rate fell 45 basis points to 0.3137% on Monday. This is more than 100 basis points below the record level of 1.318% which was as recent as last month. Of course, anyone who held U.S. Treasuries before 2020 took advantage of the incredible rally. But that leaves future investors with a grim reality of collapsed returns, bringing the United States closer than ever to Germany and Japan.
Investors flocked to Treasury bills just last week to protect themselves from a rapid slowdown in global economic growth due to the coronavirus epidemic. This week is something more. Oil prices plummeted more than 30% after Saudi Arabia declared a price war and the OPEC + alliance broke down. The same is true for breakeven points, which are the measure of inflation expectations on the bond market. The 10-year rate collapsed by more than 30 basis points, the largest decline since November 20, 2008, to around 1 percentage point, the lowest since March 2009. The five-year rate is 0, 8 percentage points and the two-year rate is less than 0.5 percentage points.
This is bad news for the Federal Reserve, which desperately wants inflation to meet or exceed its 2% target after years of non-compliance. While oil prices have historically been volatile, a shock of this magnitude cannot be ruled out by simply focusing on the “basic” measures that exclude energy and food prices. It will affect Main Street and Wall Street.
The sharp drop in oil prices is even worse for the credit markets. The Markit CDX North America High Yield Index, which tracks the cost of default insurance, jumped 145 basis points on Monday, the largest data increase ever recorded since 2012. It is at a striking distance of the highest level ever recorded. The investment category fear indicator jumped the most since the Lehman Brothers collapse.
More specifically, the significant drop in oil prices has immediate consequences for speculative energy companies. At the end of last week, their yield spread widened to 1,080 basis points, up from just 612 basis points in January. This will only get worse, and the spread could soon reach a record level, judging by recent trade. A bond from Chesapeake Energy Corp. maturing in 2025 with an 11.5% coupon entered in 2020 at a price slightly below 100 cents on the dollar. The same stock, with a composite triple-C credit rating, traded at 27 cents on Monday.
Investors are even losing confidence that some companies will survive over the next two years. The debt of Antero Resources Corp. due in November 2021 plunged from 37 cents Monday to 46.5 cents, while stocks at Whiting Petroleum Corp. maturing in March 2021 fell from 25 cents to just 20 cents. There will be bankruptcies and defaults, period.
The scariest prospect for bond traders is that this deflationary spiral is catching other parts of the credit markets that are tapped to the brim. It’s no secret, for example, that the universe of triple B rated corporate bonds has grown to more than $ 3 trillion, up from $ 800 billion at the end of the last recession. Borrowing costs remained historically low in the post-crisis period, prompting first-rate businesses and risky newcomers to finance themselves with debt. Carrying a vulnerable balance sheet can work when inflation is low but stable alongside economic growth and when credit markets are largely open to business. The question is whether one of these assumptions is still valid.
Bond traders expect the Fed to do what it can, up to and including reducing its short-term policy rate to the lower limit of 0% to 0.25% to short term. Such a move, in theory, would stimulate inflation. I am skeptical, judging by the years of stagnant price growth in Europe and Japan. The same is true, apparently, of the European Central Bank and the Bank of Japan. There is a reason why no one is in a hurry to further lower interest rates in negative territory.
As Lois Hunt of Hoisington Investment Management told me last week, “When short rates start to go down to zero, before you even reach zero, you hit a reversal point and the counterproductive effects of lower rates offset the beneficial effects lower cost of borrowing. ”
Banks are one of those industries that feels the pinch. They have fought hard enough with short-term rates close to zero and longer-term yields around 2%. How are they supposed to earn net interest income now, with a 10-year yield of 0.5%? Investors are not waiting to find out: the KBW Bank index plunged around 10% on Monday.
With the coronavirus epidemic, there was always the feeling that it might not be as bad as the worst case. The fall in oil prices seems to have more resistance.
It remains to be seen whether this one-two punch results in outright deflation. But it seems more likely than any point in the past decade, which is a worrisome sign for bond markets of all walks of life. Flocking to treasury paradise provides almost no income. The yield-seeking trade quickly collapses into the riskiest debt. One of the cornerstones of the longest expansion in U.S. history – a benign corporate default rate – no longer seems as solid.
The bond markets have cracked. Any further move towards deflation would most likely create a chasm.
To contact the author of this story: Brian Chappatta at [email protected]
To contact the editor responsible for this story: Daniel Niemi at [email protected]
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering the debt markets. He previously covered bonds for Bloomberg News. He is also the holder of the CFA charter.
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