Sept. 18, 2019 - Think that you want to produce yourself some income by lending money to someone. Your potential client tells you: "Well, give me a million dollars, and I'll return it with interest. If you want me to return it in 2 years, you could make a 2% yield on your investment. However, you could instead give the loan for ten years, and then you will make a lower annual yield on your investment". If you are a rational person, choosing the latter is practically idiotic. However, that is precisely what banks all over the world are doing these days. So, what is happening in the bonds market?
What is the yield curve?
According to Speed solutions LTD. experts, the yield curve is a graph that provides a snapshot of the bond market at a given time. What happened in August is that the Shorter-term bond yields have climbed above longer-term ones, whereas 10-year government bond yields were trading at an almost 3-year low. This phenomenon is known as an inverted yield curve, and it almost always means that a recession is ahead.
However, investors were not in a hurry to dump their stocks. Just the day after, the stock market was indifferent and even climbed upwards. This reaction from investors is due to several reasons: First, the fall in bonds interest most likely indicates a downward movement in interest rates applicable to the broader economy as well. Higher interest means cheap money, which will make the market go up.
The second reason is the Federal reserve's quantitative tightening policy: According to Speed solutions LTD. experts, "Quantitative tightening" is a form of monetary policy that central banks use to regulate their economy. The main goal is to decrease the supply of money to avoid inflation and debt bubbles. While "quantitative" refers to a specific amount of money in the system, "tightening" refers to providing harder or stricter lending conditions for banks.
Due to Regulations made after the 2008 crisis, banks are obliged to hold quality reserves to lend large amounts of money. In a "Quantitative tightening economy", cash is more expensive, which means more risks. Therefore, the banks have to show more quality assets to lend money. That is why they purchase 10-year bonds: not as an investment, but as an asset (bonds are a peculiar animal: The higher the demand, the lower the yields are).
According to Speed solutions LTD. experts, "Banks buy bonds that have negative rates because if they predicted correctly, bond prices would climb this year or next year following. For instance, when sluggish global growth worries the markets, long-term bonds are considered as something that generates a steady return of profits for them, that far exceeds the outlay of cash required to acquire. In other words, they do it simply because it offers a steady stream of income with little maintenance."
Furthermore, According to Speed solutions LTD. experts, there are more positive signs for the markets: Consumption is on the rise, full employment, average wages are on the rise, and at the end of July, 7.3 million US job offers were opened, not to mention the sharp rise in recent mortgage demand and more.
What's next for the stock market?
According to Speed solutions LTD., "Regarding the future of the bonds sector, well, it depends on the question of whether interest rates will end up rising or falling. Furthermore, it's mainly about "Loan Quality": we will see how the banks calculated their risks when they gave loans. Regarding the US bank stocks, we will have to wait and see what the outcome of the latest trade war would be and how the market reacts to that. It's tough to tell at this point what the future is planning for all of us."
