Some US investors are girding themselves for the once-inconceivable prospect that the 10-year Treasury yield could be headed towards zero, as this year's giant rally in bonds shows few signs of easing.
In a world awash with roughly US$17 trillion ($26.7t) of negative-yielding government debt — meaning buyers are guaranteed to get back less than they paid, via interest and principal, if they hold to maturity — America's government bond market has long offered refuge to investors seeking higher returns.
German government bonds maturing in 10 years now yield minus 0.70 per cent, while Japan's 10-year debt yields minus 0.27 per cent. In that context, the 1.5 per cent yield on the 10-year Treasury looks attractive.
But roughly a month ago the 10-year note was yielding about 2 per cent. The tight timeframe of that 50 basis-point slide has caught investors by surprise, leading some to put the prospect of further heavy falls on their radars.
"We could see zero," said Nick Maroutsos, the co-head of global bonds at Janus Henderson in Newport Beach, California, noting that any sell-off in bonds so far, causing yields to rise, has been met with immediate buying.
"The probability is increasing, particularly as we drop so rapidly."
However, while he expects 10-year yields to break 1 per cent before long, he is more cautious on putting a timeframe on a move through zero. For one thing, he points out that the policy likely to turbocharge the move downwards — negative short-term interest rates from the US Federal Reserve — seems a very remote prospect.
"While central banks in Europe and Japan have put all their eggs in one basket to use negative interest rates to stimulate growth, [and] the Fed is watching closely . . . we're not at the point yet where the US is going to fully embrace that unless they see some real-life concrete examples of it working," Maroutsos said.
The European Central Bank's deposit rate currently sits at minus 0.4 per cent, having been set below zero since June 2014. Japan's central bank adopted a negative benchmark interest rate in 2016, and it now charges commercial banks 0.1 per cent interest for some of the reserves they keep on deposit.
In the face of gloomy global growth and the US-China trade dispute, both the ECB and Bank of Japan have signalled a willingness to lean more heavily on this negative-rate policy.
The US central bank has also left the door open for additional stimulus, but its target policy rate is well above zero, aiming at 2 to 2.25 per cent. Moreover, the relative strength of the US economy means there is resistance to pulling too forcefully on this lever.
For these reasons Bill O'Donnell, a rates strategist at Citigroup, said that while the 10-year note was headed to zero, it could be some time before it reached this level.
"One thing that is very clear to me in the midst of all of this cacophony of headlines is that there is absolutely no indication that rates are set to rise from here," he said.
But, he added: "Right now stocks are still not far from their record highs, the labour market looks to be in really solid condition and the US economy is still doing fine."
Steve Major, global head of fixed income research at HSBC, has a similar view. "To jump from here to zero is a long way," he cautioned.
"But the chances of yields going back to where they were at the beginning of the year? Forget it."
Fed chair Jerome Powell recently underlined the strength of the US economy, stating at the central bank's annual meeting in Jackson Hole that it was in a "favourable place".
While Powell prefaced his remarks with a pledge to "sustain the expansion", other members of the policy-setting committee have publicly pushed back on the need for additional stimulus.
As such, Scott DiMaggio, the co-head of fixed income at AllianceBernstein in New York, said there was a risk that the Fed underdelivered.
"The dissension . . . paints a picture that the Fed is trying to stay more balanced," he said.
"They are trying to keep some optionality."
Traders are currently pricing in a more than 90 per cent chance that the Fed will cut its benchmark interest rate a quarter point at its upcoming meeting in September, with at least another three cuts by the end of next year.
Still, if the Fed were to follow through with the over 100 basis points of easing built into market expectations at the moment, its benchmark interest rate would be down to roughly 1 per cent.
For investors to ratchet their easing expectations higher, paving the way for the 10-year note to hit zero, the outlook for US growth would have to change dramatically, said O'Donnell.
"I hope it's not sooner than a couple of years," he said. "I can't imagine the news that would cause that. It would be nothing good."
Written by: Colby Smith
© Financial Times