How low can bond rates go?

Giddy investors in stocks have shrugged off worries about the impact of the coronavirus outbreak on the global financial markets. The S&P 500 and Nasdaq both closed at new all-time highs Friday.

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Paul R. La Monica
, CNN Business
CNN — Giddy investors in stocks have shrugged off worries about the impact of the coronavirus outbreak on the global financial markets. The S&P 500 and Nasdaq both closed at new all-time highs Friday.

But bond investors are far from euphoric.

Yields on long-term bonds have been falling as of late. The 10-year US Treasury yield is now around 1.59% -- down from 1.92% at the start of 2020 and well below its 52-week high of 2.76% from March 2019.

That's a sign that fixed income investors are nervous about the economy and are flocking to the safety of US bonds. Yields fall as demand for bonds (and their prices) rise.

And there are growing expectations that the Federal Reserve might need to lower interest rates some time in 2020 instead of standing pat.

"The Fed will be pushed to cut rates later this year. The global economy is not as strong as thought," said Marvin Loh, senior global market strategist with State Street Global Markets, in an interview with CNN Business.

While investors are currently pricing in just a 10% chance of a rate cut at the Fed's next meeting in March, the odds of the Fed easing rise dramatically for the remainder of the year.

Traders think there is a 44% chance of a cut by June and an 82% chance of at least one by December.

Flatter yield curve is a cause for concern

Bond investors are nervous that a portion of the yield curve briefly inverted earlier this month, meaning that short-term rates were higher than long-term yields. In this case, 3-month Treasury note yields topped the yield on the 10-year.

When that happens, it is a sign of unease in the financial markets, and it has often been a good predictor of an eventual recession.

Fortunately for investors, the curve is no longer inverted. It's just relatively flat with the 3-month yield at 1.57% and the 10-year yielding 1.59%.

And the spread on the more widely watched part of the yield curve -- the difference between the 2-year Treasury and the 10-year -- is much wider. The 2-year is currently yielding 1.43%.

Still, Loh said that it's not out of the question for the 10-year Treasury yield to test the lows of 1.32% from 2016. He thinks the Fed will probably be reluctant to cut interest rates into negative territory as Europe and Japan have done.

But going back to zero like the Fed did in the wake of the 2008 financial crisis is possible. The federal funds rate is currently in a range of 1.5% to 1.75%. So there is still a bit of room for the Fed to lower rates.

That seems to be a reason why many investors have flocked to bond funds lately. They are so nervous that they are willing to tolerate low bond rates because they view Treasuries as safe havens for their money. They are guaranteed their principal even if that investment doesn't generate much (if any) in the way of interest.

"Investors continue to rank capital preservation over yield. So far this year bond funds have collectively taken in twice as much money as equity funds while delivering less than half the gains that equity funds have," said analysts at research firm EPFR Global in a recent report. According to EPFR data, bond funds took in $23.6 billion in the past week, the highest level in nearly five years.

5G disrupting the bond market as well as the tech sector

There's another reason why interest rates (and hence bond yields) could fall even further: the impact of technology on the broader economy and labor market.

The increased use of 5G technology should lead to more automation and even robot workers. That would hurt the broader job market, said Mondher Bettaieb, head of corporate bonds with Vontobel Asset Management.

With that in mind, Bettaieb told CNN Business that market conditions could go from being in a "lower for longer" type environment for rates to "lower forever." In that scenario, stocks would likely be better bets than bonds.

"5G will have an impact on jobs and wages. Inflation could be a thing of the past and may not come back in a meaningful way," Bettaieb said. "This will enable the Fed to justify continued low rates in order to drive consumer spending."

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