Continuing our discussion about central banks and markets, something strange happened this week. The yield curve on the 10-year US Treasury bond inverted — that is, the returns on the bond were lower than that of a shorter-term two-year bond. Something similar had actually happened once before this year, in March, when the returns on the 10-year bond were lower than that of a three-month Treasury bond.
In the world of finance, bond yields inverting are almost as rare as a celestial event, like viewing Halley’s Comet. The last time humans were able to see this comet was in 1986. The next time will be in 2061.
To understand why inverted yields are counter-intuitive, think about the first rule of finance. A dollar today is worth more than a dollar tomorrow. This rule essentially applies the important scientific dimension of time to money. If you were to loan someone $100 for a three-month period, the interest rate you would demand is clearly lower than if you were to loan that same person for a ten-year period.
Why? Let’s try proving this by contradiction. If you ask for a lower interest for a 10-year loan, the borrower will gladly accept your terms, use your money for his three-month project, and then reinvest your money in another project for nine years and nine months (the balance of the 10-year period) for free. And he would do this at a cost lower than a three-month loan that someone else is offering. Your low-interest offer just does not make sense. Yet this is what happened in world bond markets this week.
Immune to market volatility
The US Treasury bond is the world’s most risk-free investment. It is considered to have a beta of zero, which means that no matter what happens to market volatility, a Treasury bond retains its value — both principal and interest. Gold and silver also approach zero beta levels, but the world still accepts the Treasurys as the only reliable zero beta asset.
This privilege is derived from the power of the US dollar in global trade. More than 93 per cent of all financial transactions involve the US dollar even if a US entity is not involved. It is also rooted in the “full faith and trust” promise of the United States explicitly stated on each Treasury, meaning that the US government will back all Treasury bonds.
The government, after all, controls lots of assets — land, rights, and licences to mine, the ability to tax its citizens, the right to print dollars, etc — so, a piece of paper backed by the US government is considered risk-free.
Discounted bonds
When first issued at an auction, US Treasury bonds are priced and sold on a discount basis. A $1,000 bond with a maturity period of 10 years and a 2 per cent rate is sold at auction for $820.35 . If you bought this piece of paper, you can do one of two things.
You can hold on to the bond for ten years, and walk into a bank to exchange your bond for the full $1,000. (You would have earned a compound interest rate of 2 per cent). Or you could take your bond to the secondary market in a few months’ time and sell it to someone else.
Secondary market scenarios
It is the secondary market for bonds that is a vital piece of the global economy. Suppose you decide to sell your bond a year after you originally bought it. Three scenarios apply.
— The economy is identical to a year ago, meaning that interest rates have not changed. Your bond is still worth a 2 per cent return. You bought the bond and used it up for a year, earning $16.41 in interest. You would sell the bond for the balance of the 9-year term at the same 2 per cent — at a price of $836.76. This, at a 2 per cent annual compound rate, means that the buyer of your bond would walk into his bank and cash it for $1,000, nine years later.
— The economy is hotter than a year ago, meaning that interest rates have risen. If everyone else is getting higher interest rates, a buyer of your bond would be foolish to pay you $836.76 for your bond. He will demand a discount. Say, the current interest rate is 3.5 per cent. What would be the value of a bond that grows 3.5 per cent annually back to $1,000? The answer is $733.33. This is the only price at which you can sell your bond.
— The economy is slower than a year ago, meaning that interest rates have fallen. Now, you could demand that you need to be paid more than the $836.76 price. Say, the current interest rate is 0.5 per cent. Your bond would sell at $956.10 because this would limp its way to $1,000 in nine years.
Interest rate-bond price correlation
The above scenarios underline the most important rule of bond markets. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
Central banks the world over are nudging interest rates lower — that is, nudging bond prices higher. What happened this week was strange because investors are so afraid of volatility in the global economy that they began to bid up the prices of longer-term Treasurys higher, and higher, and higher. Which means that they began to drive interest rates, or yields lower, and lower, and lower.
At one point this week, they drove the interest rate so low that the yield on a 10-year Treasury bond fell below that of a two-year note. The PBS Newshour website quoted these remarks by David Wessel, a fellow at the Brookings Institution: “The bond markets around the world seem to be suggesting they see some pretty gloomy times ahead. It doesn’t mean they’re right, but it’s a signal worth contemplating”.
So, we are in uncharted waters. Welcome to the new global economy.