Economics Weekly - Despite rising supply, global bond yields still fall; Weekly economic data preview - Is the US Fed any closer to buying treasuries?
Economics Weekly - 16
Despite rising supply,
global bond yields still fall
As the Bank of England
embarks on a Â£150bn programme of buying securities from the private sector that
will not be financed by an equivalent issue of government paper - so called
quantitative easing â€“ bond yields are falling around the world. This is perhaps
partly because of a perception that others around the world may also join the UK central bank in
purchasing government debt, although there is no convincing evidence yet to
support such a view. Indeed, the most likely reason for what is a coordinated
fall in global yields could simply be the fact that the economic data flow in
the last few weeks has been very poor for most countries. Admittedly,
government bond yields in the UK have fallen more sharply than most this week,
owing to the start of quantitative easing by the Bank of England, see chart a.
This has left UK 10 year gilts yielding just under 3%, below the equivalent German
government bond for the first time in seven years, though still above the US 10
Of the Â£150bn of unfunded debt purchases planned by the Bank of
England, Â£100bn will be spent on UK government gilts, or
roughly equivalent to one third of the entire stock of conventional gilts at
end 2008. (Quantitative easing has all sorts of other implications for
financial markets and we will consider some of these in a future article).
However, our focus is not on the UK gilt market alone but on
the general decline in major developed country government bond yields that has
occurred in the last few weeks. What appears to be the best explanation for
this and what does it mean for the shape of the yield curve in the months ahead
and prospects for economic recovery.
Weaker economic growth
and falling inflation explain sudden dip in government bond yields around the
Calculations suggest that
net new debt issuance by governments around the world will be of the order of
$3trillion in 2009, after $1trillion in 2008. This may not come as a surprise
to many and, in fact, could even be an underestimate, since new spending
initiatives are being announced seemingly every week. Hence, no one is sure
what the total liability of the many packages to counter the threat of
deflation, of bank and financial market firm rescues and to boost economic
growth will mean for government spending until after the year is out. What is
sure however, is that it will entail a significant rise in debt issuance to
fund this spending increase. A rise in bond supply should mean a fall in global
bond prices and therefore mean a rise in yields but bond yields are falling,
i.e. prices are rising. Part of the explanation is that the collapse in so many
asset markets (equities, property, commodities etc) around the world is making
government bonds the safest place to put investment flows, so encouraging buying
of government debt.
Charts b, c and d show
that the reason why bond yields have fallen is that there has been a steep dive
into recession in the US, UK and Euro area economies
in the last quarter of 2008. Further, the flow of economic data so far in Q1
suggests that this recession has deepened rather than eased. And the reason why
a fall in nominal yields is entirely sensible is that without it, real yields
would have risen given a fall in current consumer price inflation. This would
mean a rise in the cost of borrowing at a time of worsening recessionary
conditions and so would be inimical to economic recovery. We have calculated a
measure of â€˜realâ€™ bond yields by deflating nominal 10 year government bond
yields in the US, UK and euro area with
consumer price inflation for the relevant time period.
The result of this
analysis shows that real bond yields would be rising quickly and be
significantly higher than in the last few months. Fortunately, forward looking
inflation expectations derived from index-linked gilts show that inflation
expectations are falling, see chart e. The reason is shown in chart f, which is
that consumer price inflation is falling very sharply and so 10 year ahead
inflation expectations in the bond markets have fallen back. This means that
the ingredients for economic recovery are still in place. This in turn implies
that bond yields further out along the maturity curve, 2 years to 10 years and
beyond will be low and flatter than otherwise in the months ahead. This is something
that governments want to see to encourage economic recovery through a lower
cost of borrowing for companies and households at a time of rising
unemployment. A change to this mix of low inflation expectations and low bond
yields is unlikely to occur until economic recovery looks like a real prospect.
The Bank of England was the first among the
worldâ€™s leading central banks officially to start the purchase of longerterm government
debt or gilts. The US Fed signalled at the
January FOMC meeting that it was â€˜preparedâ€™ to start buying government bonds as
well. One question this week is whether the Fed will take the plunge and
announce on Wednesday it will buy US government debt. In the
UK, on Wednesday the minutes of the March 4/5 MPC meeting will give a detailed account
of the discussion that led to the cut in base rate to 0.50% and to the MPC
agreeing to buy gilts. UK unemployment data will
be published on Wednesday and may show a rise above 2 million in the total
number of unemployed.
ô€‚„ Strong participation last week at the first so-called reverse gilt
auctions by the BoE ensured a flawless start to quantitative easing (QE) in the
UK. The plan is to
gradually increase the size to Â£5bn in two auctions this week, focusing on
longer term paper on Monday (10y-25y) and on medium term paper (5y-10y) on
Wednesday. The objective of QE is to inject liquidity in the economy and
increase the level of nominal spending through a widening of the monetary base.
We will carefully monitor changes in the BoEâ€™s balance sheet and swings in
indicators of money and credit growth to asses the success of the BoEâ€™s
purchases. The auctions helped last week to bring down UK 3-month Libor to
1.87% and narrow the Libor/Ois spread to 139bp, signalling a further modest
thawing in credit market tensions. The minutes of the March MPC meeting are due
on Wednesday and are expected to reveal a unanimous vote for the cut in base
rate to 0.50% and for an immediate start with QE. Any disagreement on the
committee is likely to relate to the size of the rate cut (Blanchflower may
have preferred a 75bp move), whilst we may also hear a range of opinions on the
effectiveness of QE and the expected lag before it feeds into the real economy.
BoE governor King may discuss the credit environment at a speech on Tuesday. UK unemployment has been on
a steady upward trajectory now for almost a year and we suspect this continued
in February. Claimant count figures will be released on Wednesday and may show
a rise of around 80,000. The ILO unemployment rate is forecast to have edged up
to 6.5%. Public finances for February are due on Thursday. February
traditionally marks a fairly static month for public finances but it could be
different this time around as a weak economy curbs the inflow of tax receipts
and boosts public spending. We expect the cumulative PSNCR to have widened to
Â£26.1bn, more than double the cumulative cash requirement one year ago.
ô€‚„ The likelihood that the Federal Reserve decides to follow the BoE
and start buying treasuries cannot be ruled out when the FOMC meets on Tuesday
and Wednesday. Two-day meetings generally allow the Bank more time to discuss
in depth the state of the economy and the impact of existing funding and
liquidity programmes. The fact that the Fed changed its position in January and
said it is â€˜prepared to purchase longer-term Treasury securities rather than â€˜studyingâ€™
the purchase cannot be downplayed and means markets will be alert to the Fed
stepping in, especially if it believes that conditions in private credit
markets have not sufficiently improved. Treasury yields have been fairly
rangebound since the January FOMC meeting despite sizeable (and well received)
10y and 30y treasury auctions since then. This could lead the Fed to delay the
outright purchase of government paper and instead reiterate its pledge to do so
if market conditions change. The Fed funds rate is expected to stay at 0.25%.
The Fed will this week also accept the first applications for the Term Asset
Backed Loan Facility (TALF). The first 3-year loan grants will start on March
25th. The TALF is aimed at generating lending to consumers and small businesses
and the size of the programme could reach $1 trillion. US data this week are
forecast to show a fall in annual CPI in February to -0.1% (Wednesday) and weak
housing construction in February (Tuesday).
ô€‚„ Extremely weak German industrial orders and output data were
published last week, indicating that the contraction in Q1 gdp could be even worse
than in Q4 2008. This will put the spotlight on ECB president Trichetâ€™s speech
on Monday and on the German ZEW survey on Tuesday. It is our view that the
spectacular rise in the ZEW last month was exaggerated and is poised for a
correction as economic reality sinks in. The relief rally in equity markets
last week may well support confidence but may be less relevant with regard to
the short-term economic outlook. Data on Thursday is forecast to show that euro
zone industrial production dropped 15% y/y in January.
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