The bid for safe assets is due to volatility

The Wall Street Journal headline on European markets today is “German Bonds Surge to Record Levels” with a subtext of “Investors Seek Safety of High-Grade Debt as Fears Grow About Eurozone Economy”. This sums up the mood on both sides of the Atlantic as equity markets experience convulsions.

Yesterday I claimed that weak growth was a main driver behind the plunge in yields. Nominal GDP growth expectations are plunging as both market-based measures of inflation expectations falling and real growth expectations getting revised down, with the IMF revising down global growth expectations yet again. And while it is true that weak growth is a main driver of the fall in safe asset yields, it is also true that we are seeing a reversal of the private portfolio preference shifts into risk assets that central banks have been trying to foment.

For example, if your fixed asset portfolio was not generating sufficient nominal yield because of the drop in fixed income yields as central banks went to zero rates, moving up the risk curve to higher dividend-paying shares or to REITs or Trust Preferred Securities maintained your payout, albeit with a higher risk of loss of principal. But, the recent selloff in shares highlights the potential loss in principal and we are thus seeing a flight to quality as a result.

The bull market in bonds is not over. The need for safe assets is just as acute and fewer assets today can be considered safe. In the US, we have lost a lot of private-label AAA assets due to the mortgage-backed security meltdown. And in Europe, we have lost a lot of government bond assets due to the sovereign debt crisis. Market volatility magnifies the need for safe assets and will mean yields will go lower as inflation expectations remain low and fall further.