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Inverted yield curve? So what! What if yields turn negative?

(Note: companies that could be impacted by the content of this article are listed at the base of the story (desktop version). This article uses third-party references to provide a bullish, bearish and balanced point of view; sources listed in the "Balanced" section)

The Dow Jones Industrial fell more than 800 points on August 14 ^th when the yield on the 10-year treasury bond fell below that of the 2-year treasury note. Much has been made about the inversion of the yield curve and how that often signals a recession. Less has been made about the fact that the government bond yields are now below 2% and appear to be headed lower. Prominent bond experts such as Mohamed El-Erian and Alan Greenspan say they would not be surprised to see rates go negative. The reason for the decline is obvious. Investors are losing confidence in the economy and moving money from the stock market to places of security. Will this lack of confidence become a self-fulfilling prophesy as decreased investment and spending cause economic weakness (bear case) or is it a mere coincidence (bull case)?

Germany and Japan yield curves have been negative for years and their economies did fine. Fitch reports that there are nine countries offering 10-year bonds with a negative yield with France and Austria bond yields becoming negative this week. Negative yields are more a function of central bank policy than consumer sentiment. In fact, there are $13 trillion of debt with yields below zero. Bottom line, negative yields are not unusual globally.

Fed target rates are above current market rates. This may ease the ability of the Fed to lower key rates without causing a shock to the system. The Fed can move quickly to offset signs of economic weakness and may very well do so at upcoming Federal Reserve meetings.

Isn’t this really about the tariff war? The stock market has shown that it is very focused on the trade wars between the United States and China. Note the market’s positive reaction when the administration announced that tariffs would be delayed until December 15. Further signs of a tariff war détente could quickly provide a shift in investments out of the bond market and back into the stock market.

Negative interest rates would result in a weaker dollar that could spur investment in the US economy. The US dollar is a global store of money. Much of that wealth is held in US government bonds. Lower US bond yields will decrease the appetite of global investors to hold US dollars. This would lower the dollar exchange rate and help exports.

We’ve never been here before. Although there are examples of negative bond yields in other countries, US bonds are different. US bond yields have never turned negative. In fact, the 30-year bond yield had never dropped below 2% until this week. Importantly, the dollar, unlike other currencies, is used not only for transactions but as a place to store wealth. Foreign investors and governments hold approximately 40% of the $17 trillion in public US debt. China holds more than $1 trillion in US debt. Should bond yields turn negative, it is unclear how nations like China will react to a negative yield.

Falling bond yields are just another sign that the economy is weakening. Consumer confidence, durable good orders and transportation shipping have already taken sharp downward turns. Even if movements in the bond market prove to be temporary, actions being taken today by corporate executives and individuals cannot be reversed.

We are operating within a global economy and other countries aren’t looking very good. Technological improvement increased the ability of nations to trade with each other. Communication is instantaneous. Shipping costs are down. Consequently, the idea that the US can operate by itself and protect itself against the impact of other economies is just not feasible. One shouldn’t count on improved economic conditions overseas helping improve our economy.

Forget trade wars, what happens if we have a currency war? Should the US government make a concerted effort to lower rates further, it seems likely that it may be met by lower rates overseas. Other countries do not face the central bank independency issues that the United States faces. The idea that lower yields will stimulate the domestic economy through currency devaluation starts to fall flat if bond yields in other countries are also falling.

There is no doubt that the bond market is signaling that the economy is slowing down. What’s more, other economic leading indicators are confirming weakness. It is almost meaningless to debate whether that means a slowdown, a recession or even a depression. Either way, investors have a reason to be concerned. U.S. Bond yields have fallen to levels never seen before, which means there is not historical data to give investors some direction as to what will happen to markets. If U.S. bond yields were to continue to fall and dip into the negative yield territory, there is no telling how investors will react. Will they view rates as too good to ignore and begin borrowing funds to make purchases or investments? Or, will crossing the psychological barrier of negative yield panic the market and accelerate the flight to quality that caused bond yields to drop in the first place?

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Inverted yield curve? So what! What if yields turn negative?

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