Negative rates in Europe – We all fall down

repo market

The second quarter of 2019 was interesting for fixed income. The U.S. economy continued to do well, as job growth continued, and the unemployment rate dropped. Contrary to conventional wisdom, however, interest rates didn’t rise in response – they fell. Why did this happen? Well, global growth slowed, and the China – U.S. trade war heated up, causing concerns about future U.S. growth. 

Europe’s long-awaited growth rebound remains just that – still waiting. Low inflation and weak economic growth have forced the European Central Bank to push rates into negative territory again. The German 10-year Bund has been pushed to minus 0.38%. This means that if you buy a German Bund, you pay them for the privilege of holding your money. This, of course, disincentivizes investing in the Bund and encourages investing in assets that produce a positive return. In a perfect world, all excess European cash would stay in Europe to be lent there. But as we all know; the world isn’t perfect. 

Much of this money leaves Europe and finds a home in the U.S. Treasury market. Although U.S. interest rates are near three-year lows, they are still positive, and are profoundly better than the next best alternative. This phenomenon has driven U.S. interest rates lower than they might otherwise be. 

Another contributor to fears of slower growth and lower rates is the tariff war between China and the U.S.. With neither side willing to give an inch, it doesn’t look like this issue will be resolved any time soon. Recently the U.S. delegation thought they had reached a deal, but the Chinese pulled the rug out at the last minute, reportedly by removing conditions already agreed upon. This type of behavior appears commonplace in China. 

In my opinion, the Chinese are unlikely to either admit to stealing intellectual property or commit to changing the way they do business. They’ve built their economy on this type of activity and, with U.S. manufacturers eager to sell to their 1 billion consumers, feel they have no need to change. For these reasons, it appears China may be trying to draw out trade negotiations in hopes of a better deal with a different U.S. administration. 

Given these challenges, the result has been lower interest rates in the U.S., and the high probability that the U.S. Federal Reserve will reverse their previous tightening course in coming weeks. In the last three months, we’ve seen the benchmark 10-year Treasury rate go from 2.50% to under 1.95%. This decline anticipates a half-point reduction in short-term rates in the coming months, with a quarter point cut coming at the July Fed meeting. 

As the chart above shows, interest rates since 1999 have generally trended down. Even with historically good economic numbers and low unemployment, the U.S. can’t seem to push above 2.5% in the Fed Funds rate. Markets are expecting money market rates to fall back to around 2.00% (or even lower) in coming months.