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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  

Financial uncertainty 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 – 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 haven…

Long-term government 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 has fallen

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 and more 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 fallen.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 22 September 2008


Financial institutions 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.


• 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.


• 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.


• 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.

Jeavon Lolay, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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