Economics Weekly - Flight from risk is making bonds overvalued; Weekly economic data preview - Financial institutions in the spotlight
Economics Weekly 22 September 2008
Flight from risk is
making bonds overvalued
means that the economic signals from bond and financial markets are highly misleading
at present. The drying-up of liquidity has exposed the fault lines in developed
economies' investment bank business models of the last 10 to 15 years as being
fatally flawed - too much leverage, underpricing of risk, dependence on low
interest rates and inflation, lack of regulation â€“ so there is a flight from
risk. This flight is from a range of financial markets, including equities,
emerging markets, corporate bonds and some commodities. Much of the money
flowing out of these markets has found its way into government bonds, driving
yields down to exceptionally low levels. The question is how sustainable this
is and what economic signals it is sending, if any?
Government bonds are
seen as a safe havenâ€¦
bonds are regarded as a guide to inflationary pressures in an economy. This stems
from a view that the nominal return on a fixed income bond is made up of a real
yield and a premium to compensate for the risk of inflation and for actual
inflation. In recent weeks, the yield on government bonds has fallen sharply in
global markets, in particular in the US, euro zone and UK. This has been the
case in global markets in recent months, but especially since the failure of Lehman,
Merrill Lynch, AIG, Fannie Mae, Freddie Mac etc. We show this trend in charts
a, b and c for the US, euro zone and UK. The fall in long-term
bond yields (10 years in this case), without a rise in short term interest
rate, is a sign that inflation expectations have fallen. But at the same time,
the charts show that index-linked bond yields have also risen. Since
index-linked bonds are paid net of inflation, i.e. they are inflation adjusted,
this suggests that inflation concerns have eased.
...and the real yield
Events may yet overtake
what seems to be unfolding in bond markets at present, but the fall in nominal
yields below inflation-linked bonds suggests that it is the real yield
component of the nominal yield that has fallen. Hence, if confidence returns to
financial markets, expect a sharp rise in nominal government bond yields, as
the costs of the bailout of the financial sector and the inflation risk this
entails hit home.
Actual price inflation
in the US, UK and eurozone has
undergone a sharp rise in recent months. The fall in the pound and in the US$ has meant that import
price inflation is rising rapidly. In the UK it is at a 20-year
high. In the euro zone, higher oil prices have helped to push up import prices
sharply, though a strong currency has helped to offset some of this impact. In
each of these economic areas, producer prices are up sharply this year, with
core producer prices, which exclude food and energy, also up, indicating a
broadening of inflation into the wider economy. Producer output prices are up strongly
as well, and it is clear that companies have been able to pass on some of the
rise in their costs onto consumers. This is shown by the fact that consumer
price inflation rates are at 10-15 year highs in these economies. Charts d, e
and f show that inflation has risen quite sharply in each of the inflation linked yields rise economic zones in 2008.
Expected inflation is high, though it has fallen back recently in the US andmore modestly in the eurozone. In the UK, inflation
expectations continue to rise, see chart f.
But there are some
signs that inflation has peaked in the US and euro zone
Commodity prices are
coming off the boil, with oil prices down from nearly $150 a barrel to around $100
at present. It is also therefore likely that there has been some fall in
inflation expectations. Longer-term measures of inflation expectations also
shows that they remain lower than short-term measures, suggesting consumers
believe that long-term inflation will be below the current rate. Moreover,
there is perhaps a perception that weak economic growth in 2008 and 2009 will
lead to some lowering of inflation pressure.
A flight to safety has
driven bond yields lower, once this reverses, yields will rise sharply
All in all, this
analysis suggests that bond yields are likely to rise quite sharply once
economic recovery gets underway, the credit crisis abates or if price inflation
does not weaken. There is also a significant risk of a very sharp rise in the
10-year nominal bond yield if confidence in the authorities is lost, especially
in the US where government
spending is rising rapidly from the rescue of its financial institutions. With
government spending up sharply and budget deficits widening, it is clear that
bond yields are unlikely to stay low once this crisis in the financial markets
eases. In the UK, chart f shows that
there is an even greater risk of a sharp rise in bond yields as actual
inflation is still rising sharply and inflation expectations have not yet
Weekly economic data preview W/c
in the spotlight
After the dramatic
events of last week, the spotlight will understandably remain on global
financial institutions. The unprecedented rally in global stock markets last
Friday followed news that the US government will soon
announce a colossal structural solution to remove troubled assets from the
balance sheets of US financial companies. However, reaching an agreement on the
set of measures required will be difficult, especially given the growing
resistance against putting further taxpayers money at risk. Nothing should therefore
be taken for granted, particularly with the presidential election campaign
underway. The temporary ban on the shorting of financial stocks may also have
played a significant part in the rally in equities last week. Although data
this week are again likely to be overshadowed by market events, it is worth
highlighting that by in large they still show relatively limited impact on the
'real' economy from the credit crisis. However, inflation trends remain
worrying and vindicate decisions by major central banks to maintain official
interest rates this month. There are a host of central bank speakers this week,
with Fed chairman Bernanke testifying to the Senate and Congress.
â€˘ It is a relatively
quiet week for UK economic data and
their market impact is likely to be limited. After the surprisingly strong rise
in official retail sales volumes in August, up 1.2% against the consensus
estimate of a 0.5% drop, there is a strong possibility that consumer spending
growth will be positive in the third quarter. Although we expect the UK to skirt recession
this year, any quarterly contraction should be relatively modest should it
occur. The CBI distributive trades' survey this week will provide an early
guide to retail activity in September, however, it is worth noting that the
survey has been at odds with the actual data. We look for a modest rise in the
headline balance to -40, from a 25-year low of -46 in August. House price data
also feature this week. Official house price figures from the Department for
Communities and Local Government (DCLG) surprisingly showed a 1% rise in July,
contrasting with declines of 1.7% for both the Halifax and Nationwide indices
in the same month. Although it is published with a longer lag, we believe that
the DCLG series provides a more accurate assessment of UKwide house prices
because of its more representative estimation method. The chart below shows the
profiles of the three house price indices since 1988. BoE MPC members Gieve,
Sentance and Barker speak this week.
â€˘ The focus in the US this week will remain
on developments in the financial sector. However, there will also be considerable
interest in the latest views from Fed chairman Bernanke and his FOMC colleagues
on the prospects of the US economy. Mr Bernanke
has a particularly busy week, testifying to the Senate on Tuesday, to
Congress's Joint Economic Committee on Wednesday and the House panel on
Thursday. On the data front, we expect the final estimate of Q2 GDP to confirm
the US economy grew by an
annualised 3.3%, the quickest since Q2 2007. We forecast economic growth will
slow in the second half of 2008 but it should still remain positive in both quarters.
The slower pace of activity in Q3 should be reflected in reduced orders for
durable goods in August, following on from surprisingly strong rises in the
previous two months. We expect housing market data this week to show the pace
of existing and new home sales may be close to a bottom, although median prices
are likely to have fallen further and the number of unsold homes may have also
risen to a new record.
â€˘ In the euro zone, we
expect signs this week of stronger economic growth in Q3, reflected in higher
outturns for the 'flash' manufacturing and services PMIs and German IFO in
September. We expect the euro zone economy to narrowly avoid recession, after
contracting in the second quarter for the first time since the euro was
launched. ECB president Trichet speaks on Monday and other Council members take
to the stage later in the week.
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