Prospect of negative U.S. yields becomes less far-fetched as global economy struggles

Updated with correction.

A weakening global economy could push yields on U.S. government bonds to zero or lower, creating especially challenging conditions for executives at U.S. retirement funds.

For a pension executive looking to move toward a fully derisked portfolio or simply achieve moderate long-term returns, "negative yields will be a monumental challenge," predicted Tim Barron, senior vice president and chief investment officer with New York-based investment consulting firm Segal Marco Advisors.

For now, the U.S. — with a federal funds rate of between 2% and 2.25% — remains the proverbial one-eyed man in the land of the blind, vis-a-vis countries such as Germany, Japan and Switzerland, whose bonds are weighed down by negative yields now.

But analysts say the once unthinkable notion that the U.S. could join the ranks of sovereigns exacting a fee from creditors for holding their bonds is no longer far-fetched.

"This business of negative yields arriving in the U.S. at some point … is not so fanciful," said Tapan Datta, London-based head of the global asset allocation team for Aon's retirement and investment business.

When the next recession comes, it's "certainly possible that U.S. rates will return to zero, and with limited ability to stimulate, bond yields could go much lower than they did at the time of the global financial crisis," said Mr. Datta, in an email, adding "in extremis, in a Japanification scenario, U.S. yields could indeed go negative."

Some market veterans, while convinced negative U.S. yields are unlikely, note that the bar for ruling out such developments has shifted dramatically in recent years.

If someone had asked 10 years ago, "do you think that 10-year (German) bund yields would be at minus 50 or 60 basis points, I would have said 'of course not, that's ridiculous,'" said Jim Caron, New York-based head of global macro strategies with Morgan Stanley Investment Management's global fixed-income team.

But even if the odds are 15% or less, "we really need to be prepared for whatever outcome might be there," he said.

Industry veterans say the prospect of U.S. government bond yields joining their counterparts in negative territory isn't an immediate one, but growing signs of weakness in the global economy are making it an increasingly plausible scenario somewhere down the line.

"I don't think people are focused on it as an imminent thing but (they) are starting to see it as a possibility," said Greg Tell, New York-based global head of investment specialists with J.P. Morgan Asset Management's global fixed-income, currency and commodities team.

Signs of economic weakness now in Germany, Japan, South Korea, China, Singapore and Australia, among other countries, are pointing to the kind of global recession the U.S. Federal Reserve has responded to in past decades with cuts of about 500 basis points, said Hayden Briscoe, Hong Kong-based managing director and head of Asia-Pacific fixed income with UBS Asset Management.

With a potential development like that on the horizon, "a starting point of 2½% is not where you want to be," he said.

The U.S. federal funds rate "barely made it above 2% in the latest hiking cycle" so if the Federal Reserve matches the cuts of past recessions, "they would need to go deeply negative," agreed John Stopford, London-based head of multiasset income with Investec Asset Management.

Market movements Aug. 14 and Aug. 15 have pointed to growing investor concern about the economic outlook.

The yield on the 30-year U.S. Treasury fell to all-time lows of less than 2% in Asian trading Aug. 15 and the yield on the 10-year Treasury slipped to 1.56%, 3 basis points below the yield on two-year paper — the kind of inversion that's proven a reliable harbinger of past U.S. recessions. That bearish bond news, in turn, helped send U.S. stocks into a tailspin, with the Dow Jones industrial average on Aug. 14 plunging 800 points, or 3.05% — its sharpest decline all year.

While the chances of negative yields in the U.S. have increased, some market veterans expect the Fed to do whatever it can to ward off that outcome.

If there's another negative growth shock, rates in the U.S. could go back down to zero but the Fed is likely to employ "every other possible type of non-conventional policy measure" to keep yields from going negative, predicted Philip Naylor, a senior consultant with Melbourne-based investment consulting firm Frontier Advisors Pty. Ltd.

Faced with such an economic challenge, the U.S. — with rates still positive — would be in a relatively enviable position compared to countries which have "already kind of maxed out" their policy levers, said Mr. Naylor, who previously worked at the Reserve Bank of Australia.

In a Feb. 4 research note, however, Vasco Curdia, a research adviser in the economic research department of the Fed's San Francisco branch, said allowing the fed funds rate to drop below zero following the global financial crisis a decade ago might have reduced the depth of the ensuing recession, making that option — potentially — a "useful tool to promote the Fed's dual mandate."

Meanwhile former Fed Chairman Alan Greenspan, in an Aug. 13 interview with Bloomberg, mentioned negative yields in the U.S. as a possibility and suggested such a development shouldn't be seen as a big deal.

But MSIM's Mr. Caron, in an interview, said there are structural reasons to believe negative yields could prove relatively disruptive for important segments of the U.S. economy, such as banking and pension plans.

"At some point you reach what is called a 'reversal rate,' where the further you push interest rates lower or negative, it starts to do more harm than good," said Mr. Caron. "I would suspect in the U.S., there's a much bigger hurdle or barrier for yields to go really negative."

The U.S. economy, for example, is much more geared toward having private sector-funded retirement plans, as opposed to national or state-run plans, raising the importance of having access to investments with a "positive income element," he said. All that means is that the Fed will find it much harder to push rates low, extremely low or negative for a long time, whereas central banks like the European Central Bank can push them into negative territory and the average pensioner there doesn't necessarily feel it, he said.

Whether U.S. rates go negative or just return to zero, the prospect could leave pension plan executives under pressure to adopt a more dynamic approach to managing their fixed-income allocations. Investors would probably have to adopt "a more tactical approach" in such an environment, Investec's Mr. Stopford said.

While U.S. rates are on the way down, having exposure to longer-duration, high quality bonds, U.S. Treasury strips and agency collateralized mortgage-backed securities is where "you want to be," JPMAM's Mr. Tell said.

"If the U.S. long bond yield eventually goes to (zero), you would be picking up as much as 40%" in capital gains, Aon's Mr. Datta noted.

After rates drop to zero or go negative, the charms of maintaining a big allocation to bonds will evaporate quickly.

If the U.S. stops being an oasis of positive returns in a sea of negative-yield bonds, "where do you look for returns," asked Mr. Tell. "You can't just look for another currency or another government bond market," he said.

"In that sort of world, locking yourself into bond rates with expected real negative returns kind of highlights that that asset class doesn't have the same place in a portfolio that it normally would have done" — making it a challenging environment for people accustomed to anchoring their portfolios with large allocations to those bonds, Frontier's Mr. Naylor said.

It will become really important to think about a much greater mix of asset classes, including infrastructure, real estate, credit and currencies, he said.