Embracing The Growing World Of Negative Bond Yields

The trade war, while volatile and leaving investors with mixed degrees of optimism and apprehension, is likely to be with us for some time. Markets reacted strongly to the Trump Administration’s decision, on August 5, to label China a currency manipulator. The S&P 500 declined 3% that day, its largest decline for the year—and Treasury yields plummeted as investors flocked to safe haven assets. The International Monetary Fund (NYSE:IMF) released a report in July finding that China’s currency is approximately fairly valued, but the currency manipulator claim was nonetheless symbolic and impacted markets. Tension has ratcheted up since the claim, with a new round of tariffs taking effect on September 1st. Investors are now anxiously seeing what will happen to additional tariffs that are slated to take effect in December. Central banks are reacting to an increasingly uncertain and challenging world, but at this point, how effective is monetary policy?

Plunging Further into Negative Territory

Global bond yields have accelerated into negative territory since the start of the year. At the beginning of the year, $8.3 trillion of global debt was negative yielding. That number has more than doubled to $16.8 trillion. This comes at a time when central banks are increasingly cutting rates and exploring additional measures, including quantitative easing (QE), to combat the global growth slowdown. The world is well aware of Japan’s “lost decade” of anemic growth and low inflation, and chatter of Europe becoming the next Japan is building.

Source: Bloomberg, 8/3/2017 – 8/30/2019.

The “Below 0% Club”

Denmark, Switzerland, and Germany all recently had their entire government bond yield curve at negative yields.

In early July, Denmark became the first developed economy to see its entire government bond yield curve fall into negative territory. Switzerland joined the club later that month. Germany, the world’s fourth largest economy, was added to the list in early August after President Trump ratcheted up the trade war with China. As global government bond yields dipped, so too did U.S. Treasury yields. It may not be long before the 10-year U.S. Treasury yield approaches the low level of 1.36% it hit in July 2016 following the United Kingdom’s decision to exit the European Union (Brexit).

U.S. and Germany 10-year yield

Source: Bloomberg, 8/5/2014 – 8/30/2019.

Diminishing Impact from Monetary Policy?

With accommodative central banks and interest rates already so low, how much of an incremental impact can monetary policy have on growth? While the Federal Reserve was at least able to lift its benchmark rate off near 0% levels, the European Central Bank (ECB) never even got started. Fiscal policy (government spending) might need to lend a hand to revive economies, particularly in Europe. This was recently echoed by former IMF Chief Economist Olivier Blanchard: “Surely there is not enough room to respond to even a run-of-the-mill recession. Fiscal policy has a much more active role to play, and it is not yet equipped to do so.”1 In its Annual Report (June 2019), the Bank for International Settlements (BIS) made one point clear: “…what is good for today need not necessarily be good for tomorrow. More fundamentally, monetary policy cannot be the engine of growth. A greater role for fiscal, structural and prudential policy would contribute more effectively to sustainable growth.”2 While the alarm bells aren’t currently ringing, economies that continue to operate with historically low interest rates may well need to look beyond monetary policy for a boost.

1https://www.bloomberg.com/news/articles/2019-06-17/europe-s-weapon-for-next-crisis-is-fiscal-policy-blanchard-says

2https://www.bis.org/publ/arpdf/ar2019e.pdf

Investing in Treasury Moves – Consider Leveraged and Inverse ETFs

While the trend in the United States (and globally) has been lower rates, it could well be overdone. Just as we’ve seen sharp drops in yields, yields can rise quickly, especially coming from such a low base. There are a number of investment vehicles available that seek to capitalize on these movements. Investors can consider leveraged and inverse ETFs benchmarked to indexes with different exposure to the yield curve (i.e., 7-10 year, 20+ year). These types of funds provide magnified exposure and can be used in a variety of ways: to implement a high-conviction directional trade, to overweight or underweight a segment of the market, or as a hedge. Leveraged and inverse ETFs have a “one-day” investment objective and offer multiple levels of daily exposure (i.e. +/- 2x).

Remember the Impact of Compounding

Leveraged and inverse ETFs are designed for short term use. If you intend to use them for periods longer than a day, it is critical to understand how compounding impacts the performance of leveraged and inverse ETFs. Because of the daily objective and the results of compounding, it’s unlikely an investor will receive a leveraged or inverse ETF’s multiple times the benchmark’s return for periods longer than a single day. In trending periods, compounding can enhance returns, and in volatile periods, compounding may hurt returns. Generally speaking, the greater the multiple or more volatile an ETF’s benchmark, the more pronounced the effects of compounding are likely to be.

Conclusions

This market is keeping investors nimble, with trade war tension and potential for currency wars. Monetary policy may be testing its limits, as rates grind further and further into low or below 0% territory. Calls for fiscal policy considerations are here—maybe it’s time to listen a little more closely. Trading in this environment can present opportunities, and it’s important to know the range of tools you can work with.

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A Note About Risk

Investing involves risk, including the possible loss of principal. Most leveraged and inverse funds seek returns that are a multiple of (e.g., 2x or -2x) the return of a benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, leveraged and inverse fund returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holdings as frequently as daily. Most leveraged and inverse funds are non-diversified and each entails certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Inverse funds should lose money when their benchmarks or indexes rise. Please see their summary and full prospectuses for a more complete description of risks.

Bonds will decrease in value as interest rates rise.

Carefully consider the investment objectives, risks, charges and expenses of ProShares before investing. This and other information can be found in their summary and full prospectuses. Read them carefully before investing. There is no guarantee any ProShares ETF will achieve its investment objective. Shares of any ETF are generally bought and sold at market price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns. ProShares are distributed by SEI Investments Distribution Co., which is not affiliated with the funds’ advisor or sponsor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Leks Gerlak has been an Investment Strategist with ProShares since 2015. His responsibilities include portfolio analysis, education, product research and development, and the presentation of investment strategies using the company’s leveraged and inverse (tactical) ETFs. This information is not meant to be investment advice.