By Cassandra Ying
When the stock market gets more volatile, investors often turn to bonds, particularly government bonds. Since governments are typically reliable debtors, people can expect an almost guaranteed, while smaller, sum to be returned to them eventually. Bonds often serve as an appropriate indicator of how stable the economy is. In a cyclical way, when people buy bonds, prices rise, pushing yields (which are, in this case, interest rates) down. Learn more about bonds here: Basics Of Bonds.
In general, government bond yields have seen dramatic drops, from Asian economies like Japan to European economies like Britain and Germany, to Pacific economies like Australia and the United States. One aspect of yields that currently worries investors is the inverted yield curve, a signal for a possible recession. Additionally, inflation rates have been low, with investors expecting even lower ones in the near future. Economists have pointed toward several reasons for the strangely low inflation, such as advanced technology and globalization. Technological innovations have made information more accessible and improved communication, which overall increase productivity and suppress labor costs. Furthermore, globalization, especially the increase in global competition, have also suppressed costs. And recently, economic growth has slowed, a characteristic that often accompanies low inflation rates.
Specifically, Treasury inflation-protected securities (TIPS), which change based on the state of the economy, can be compared with standard Treasury bonds. The US government adjusts the value of TIPS according to the Consumer Price Index’s (CPI) measure of inflation. CPI examines the weighted average cost of capital and compares it to the cost of living. We’ve seen the inflation rates for TIPS and standard Treasury yields get closer and closer until they’re only marginally different. This suggests that current inflation is very low.
Interest Rate Expectations
For various reasons like the trade war and Mexico-US tensions, investors expect the Fed to cut rates rather than raise them in order to make the stock market seem more appealing. Lower interest rates essentially mean lower borrowing costs for people and companies. That means they are more willing to borrow money in the first place. This added incentive to borrow money equates placing money in the stock market. Moreover, lowering interest rates leads to lower bond yields throughout the bond market. Consequently, the demand for safer assets like bonds declines while demand for high return investments like stocks increases. As of right now, investors appear to be turning to the relative safety of bonds.
For the last couple of weeks, we’ve seen the same pattern play out: demand for government bonds has risen, causing prices to rise as well. On the policy side, US regulators have considered tightening control on technology giants like Facebook. As a result, investors pulled their money from the stock market to less risky investments like government bonds. With more and more signs suggesting a reduction in short-term interest rates, investors have placed their trust in short-term Treasurys or long-term government bonds.
The Current Situation
On June 4th, government bond prices have actually risen alongside the yield on the 10-year Treasury. At a conference, Jerome Powell, Chair of the Federal Reserve, hinted at potentially lowering interest rates, incentivizing investors to put more money in stocks.
Just over a week later, on June 12th, the Labor Department surprised economists with a lower than expected rise in consumer prices. The reason they expected higher inflation lies in the status quo’s growing economy and record-low unemployment rate. These two factors typically increase labor costs and prices. What we actually had was soft inflation, or a slowly climbing inflation rate, which worries investors because it indicates a less-active economy. To combat this and stimulate the economy, the Fed could lower borrowing rates, which, as mentioned before, will draw investors to the stock market.
The same week, the attack on several oil tankers in the Gulf of Oman made headline news. This simultaneously created an atmosphere of geopolitical uncertainty and sparked concerns over potential trade disruptions. As expected, we saw investors flock to the safety provided by government bonds, resulting in bond prices rising.
While the future remains unclear, economists believe soft inflation and political tension are creating a more risky environment. That will continue to play a large role in causing investors to shift from stocks to bonds. As always, those who choose to invest in bonds tend to want safe, reliable returns rather than risky but potentially rewarding ones.