The Treasury bond rush won’t end well

Many nations in recent years are trying to wall themselves off from the rest of the world, but financial markets are immune: Money is moving freely, showing financial markets at least remain as intertwined as ever.
In Asia, Australia, Europe and the Americas, yield curves are inverting simultaneously. Investors, fearing that the protectionist nations will be successful against globalisation, are increasing the demand for the safe assets of dollars and US Treasury bonds. Either the deglobalisation fears are overblown, in which case Treasury yields have probably fallen too much, or they’re real, in which case global financial market correlations should break down as countries go their own way.
These possibilities show how perverse the pricing of US Treasuries has become.
The first scenario is easy enough: Fears of the breakdown of globalisation don’t come to pass. In that scenario stock markets get a reprieve and rally strongly as the risk premium from trade tensions fades. The uncertainty causing CEOs to hold off on investment decisions evaporates, and we get at least a short-term boom in investment as delayed projects get built. Global growth turns up, and bond markets sell off hard, with yields rising around the world.
The second scenario requires a few more assumptions. It would seem to lead to bad news for those who have bought US Treasuries this month. Say we get a fairly disorderly breakdown in global trading relationships. As the Wall Street Journal’s Greg Ip noted, when assumptions underlying economic eras are shattered, global recessions are often the result. But recessions don’t last forever. In the US, since World War II the average duration of recession has been 11 months.
Given that the US has a relatively closed economy, has households and a banking system in relatively good shape, and isn’t an export-dependent economy to the extent Germany or some Asian countries are, any US recession resulting from such a global recession would probably be pretty mild.
We’ve been hearing for years that globalisation has held down inflation in the US as any build-up in inflation pressures has been easy to alleviate by importing cheap goods and cheap labour from abroad, or outsourcing jobs as wage pressures intensified. Those factors would be reduced. Just as increased globalisation has led to a convergence in inflation and interest rates around the world, decreased globalisation would do the opposite. There’s no reason why the US couldn’t have 3 percent inflation even as Germany or China dealt with deflation.
That “new normal” might mean higher inflation and lower growth, which should give pause to investors who have driven long-term Treasury yields to record lows.
It’s understandable why investors have driven yields sharply lower over the past couple of weeks. People are worried about slow global growth and are reacting to negative headlines and tweets. Even as trade and immigration have headwinds, we haven’t seen the same for the flow of capital, driving foreign money into the perceived safe haven of the dollar and Treasuries.
But short-term financial market mechanics don’t square with the two longer-term economic realities we’re confronting. Neither the “breakdown of globalisation” nor the “false alarm” scenario seems like good news for Treasury bonds once this moment of uncertainty passes.

—Bloomberg