US Bond Yield Inversion Curve Rattles Investors Sentiment

US Bond Yield Inversion Curve Rattles Investors Sentiment

Bond yields are the true measure of the return the fixed income securities hand over to the investors; also, they are considered as a proxy to the interest rates. If one plots the yields of bonds on a chart with distinct maturity dates, it usually shows a curve with an upward slope, the rationale behind this is, investors seek a higher rate of return as a risk premium for buying longer-maturity bonds. An inverted yield occurs when short-duration bond yields are higher than the long-term bond yields; this reflects that investors are feeling more risks in the near future.

The very first and foremost thing one needs to understand while discussing bond yields, that Bond prices and yield upon it are inversely proportional to each other. It implies that when prices of bonds shot up, yields decline and if bond prices go down, yields shot up. A clear understanding of the bond market could help to avoid confusion when dealing in the financial instrument.

Why does Equity investors should care about the bond yields?

Well, someone can argue that I am neither a bond investor nor a bond trader, so why do I need to be worried that, where the yields are going. Well it’s a fair question, but the rationale behind gaining the decent knowledge about the bond market is because, bond yield are great reflectors of how strong the stock market rally is and if yield is plummeting, it reflects that investors are shifting their investments to interest bearing safer securities, that’s why bond prices goes up. So, the sole reason behind the falling yields is rising bond prices, which reflects an increase in demand for bonds.

It was closely observed that an increase in Bid for bonds when investors are under the impression that their asset allocation in equities and other speculative assets classes are getting riskier, they decided to exercise an asset class swap to seek a level of safety for their hard-earned money by allocating them into bonds and in the other US Dollar backed securities, this leads to rise in US Dollars against the other major currencies.

On the other side, if yields are expanding it is because of prices of the bond are falling in the bond market, that reflect the decrease in demands for bonds. This was typically observed that when investors feel that their investments could seek a better level of income or capital appreciations if it was invested in the stock market as the stock market is or about to rally. Now, this will have an adverse effect and could weaken the US Dollars against the majors.

US Bond market sends some classic recession signals

Recently, the US bond market sent some classic recession signals, as the spread between 10 Yr. US bond yield and 2 Yr. bond yield slumped below zero. This had led Donald Trump, the US President to call the US Federal Reserve and his cabinet colleagues “clueless”. This was widely overserved that bond yields in advance sent this Kind of signal before each of the last five US recession. However, it takes a year or eighteen-month time for the recession to occur. Its usually seen that the inverted bond yield curve ends ahead of the recession beginning; however, the inverted yield did not forecast the length of an economic downturn.

However, US yield curve returned to the normal since August 14, 2019 inversion, with the benchmark 10Yr US bond yield on August 22, 2019 yielding 1.584% approximately and 0.021 percentage points higher than 2Yr US bond (at the time of writing, as on August 22, 2019, before the market close). Globally, market analysts are saying that the yield curve could again return and could continue in an inverted trend. This is a major cause of concern for the stock markets, and it could also increase pressure on Federal Reserve to slash interest rates again to provide stimulus to the economy.

Who is buying these bonds and why?

Inflating risk levels have led the investors to rush towards the bonds, that has increased demand for bonds substantially, and that’s why one can’t find the value in yield when the market is flooded with excess money. This has created a mountain of global negative-yielding bonds to trillions of dollars.

But the question is who is pouring money into an asset that guaranteed to return less than their face value?

Well, there are back-tested methods through which negative-yielding bonds could be traded for profit. The plain vanilla method is to assume that bond prices keep rising, and the next one has to buy it at even lower yields that are available today. However, there are also other strategies which are more prudent through which one negative-yielding bond could be transferred at a profit.

  • Cost of funding is even less than that of the bond’s yields by using swaps or current forward strategies.
  • Carry and roll strategy: borrowing over a relatively short duration period and allocate it to longer-maturities where yields are generally higher than bonds having short-maturities is one very popular strategy practised by bond traders globally.
  • Currency hedging: On another method to profit from negative-yielding bonds is through currency hedging. In a rising US dollar against the majors could help those who are holding funds in US Dollar to benefit from negative-yielding bonds in Europe and Japan.

How can bonds offer negative yields?

It all starts when investors subscribe to a bond for more than its face value. If the total amount of coupon rates the bond pays for its remaining lifetime is less than the premium the buyer paid for the bond, then investors losses money and the bond considered to have a negative yield. Investors who carry negative-yielding bond till maturity end up losing and getting less than they have paid for them, including interests.

Yields are a measure of profit one will make from a bond investment. The less you pay to buy these bonds, the higher the return one will generate, and the higher yields will be. And, the more price you pay for a bond, the less one will generate out of his investments or can’t find the yields.

Reason behind recent negative yield curve.

Globally, it is widely considered that ongoing trade spat between US and China is the root cause behind the current global slowdown. All this started a few months back, however, earlier it was expected that this will get resolved in couple of weeks or in few months, but it kept on growing and now has become threat for the global economic growth. The ongoing trade rifts between two larger economies are creating severe uncertainties, and this has led investors to buy investment-grade US bonds, considered to be a safe haven. This increase in demand for US bonds dragged the yields down, which reflect a strong sense of fear among the investing community in the near future.

Is UK experiencing the same situation?

No, but it is struggling into its home-grown crisis the “Brexit”. The British economy is struggling because of severe headwinds related to Brexit, which is impacting the businesses over there and dragging the economy towards the recession. Also, Sterling Pound has fallen substantially since Brexit referendum exercised in Jun 23, 2016, and it is denting financials to business especially those who earn a majority of their revenue from the UK market and import good and raw materials from overseas. Also, manufacturing activities are slowing, and consumer spending is muted, especially on big-ticket products.

At the time of writing (as on August 22, 2019, before the market close), U.K 10Yr Government Bond yield was at 0.512%, and 2-year government bond yield was at 0.513% respectively.

Market Levels

The broader equity benchmark of the UK, the FTSE 100 index was trading 27.07 points or 0.38% lower at 7,176.90, with NMC Health Plc (LSE: NMC), ITV Plc (LSE: ITV), and TUI AG (LSE: TUI) being the top-performing companies and were up by 22%, 2.2% and 2.28% respectively, while on the other side, companies like Imperial Brands Plc (LSE: IMB), Aveva Group Plc (LSE: AVV) and Rolls-Royce Holding Plc (LSE: RR) are the laggards on the FTSE 100 index and trading lower by 2.14%,2.03% and 1.99% respectively, at the time of writing (as on August 22, 2019 at 01:12 PM GMT), before the market close.

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

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