The Disconnect Between the Bond Market and Economy
I have seen that many people discuss the disconnect between the main market and stock market since the stock market has been breaking new records even though the main market has not recovered yet. However, I have not seen many explanations about the bond market, so I want to explain how the bond market disconnects to the main market.
According to economics, bond investment returns correlate to risks. If you invest in a high credit rating bond, you will have a low yield. If you invest in a low credit rating bond, you will have a high return, but the debtor also has a high chance of default. If so, you will lose all your money.
However, this formula does not work in the current market.
Let’s see the junk bond market. Since the pandemic started, the American corporate default rate has been going up. We will probably see many bankrupts because this pandemic will continue at least until next winter. Moreover, the high yield bond issuance volume in 2020 is historically high.
However, the current junk bond yields are historically low. It means the junk bond investments have become a higher risk-lower return. For example, recently, a beverage-can manufacturer Ball (BB+) sold $1 billion of 10-year bonds with 2.875% yield. According to Bloomberg, this is the lowest on record in more than five years.
The mortgage-backed security market is also similar to the junk bond market. According to CNBC, 32% of Americans did not pay housing payments at the beginning of August. Because of the high unemployment rate, this high deferral rate would seem to shift to the high default rates. However, the mortgage rate breaks the lowest yield record every day. Therefore, mortgage bond investments became a higher risk-lower return.
Those examples show that the market system does not work in the bond market. Instead, we have asset-misallocation as a consequence. That is why the bankrupted companies such as Hertz succeeded in financing from the market. The misallocation also has accelerated the stock and bond market to disconnect to the main market further.
Now the bond market has two perspectives about this current situation.
- The bond investments cannot compensate for taking risks. It means the bond yield is too low. (the price is too high) Therefore, investors should/will sell bonds. (It will cause the yield to go higher and the price to go lower.)
- Because the economy does not get recovered, the government will conduct more aggressive policies. It means the bond yield will go lower, and the price will go higher. As a result, bond investments will make the capital gain. Therefore, investors should/will buy bonds.
In the current stage, the second view is more popular than the first view. According to them, (at least the fed believes that) if the bond market connects to the main market, the corporate bond and housing markets could collapse. The fed has expressed that that situation will make people have unacceptable damages. In order to prevent people from the damages, fed makes the markets disconnect to the main market.
If the pandemic situation continues, probably in Q3 and 2021 Q1, default rates will go up more. Then, such as the first view, the market may rush to sell assets, including bonds. The second view people expect that the fed will start the two new policies, Yield Curve Control and Negative Interest Rates, to release the market that anxiety and to keep the disconnection.
Yield Curve Control means fed officially determines the bond yields and prices. If the market sells bonds more, the fed will buy as much as they sell. As a result, the bond yields and prices would not change. For instance, if the fed determines the 10 years treasury bond yields at -0.5%, many investors will leave the market because they can no longer expect interests or capital gains. If you are an international investor, you will also have another loss from the depreciation from the US dollar value.
Those policies will change the financial world further. It would not be easy to imagine that world. However, Japan gives us a hint. Since the Bank of Japan(BOJ) started QE, YCC, and negative interest rates, Japan has met the four phenomena.
- Nikkei index has increased from 10,000 to 23650 (from 2012 to 2020).
- However, since BOJ conducted the negative interest policy, the Japanese financial industry stocks underperformed because they could not find suitable long-term investments.
- More investors have sold bonds and left the market, and more BOJ has occupied the sovereign market. Now, BOJ is the largest creditor of the Japanese government. In 2020 March, BOJ held 44.2% of the Japanese treasury bonds. Meanwhile, foreign investors held only 12.9%.
- As time goes, #3 made BOJ difficult to find bonds they can buy. That was one of the main reasons why BOJ started the stock purchase program.
Red: Nikkei 225 Index Blue: Japanese Bank Index
I believe that the US also would meet those phenomena if the fed conducts the two policies. Yield curve control and negative interest rates will positively impact the stock and housing markets. The financial sectors may be struggling. Those policies will trigger the market to bet on the stock purchase program. However, the financial markets will lose the market systems. Also, because those policies lead international investors to leave the bond market, the value of the US dollar will have negative impacts.