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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 March 2009

Despite rising supply, global bond yields still fall

As the Bank of England embarks on a £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 – 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 year treasury.

Of the £150bn of unfunded debt purchases planned by the Bank of England, £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 world…

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 ‘real’ 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.

Trevor Williams, Chief Economist, Corporate Markets



Weekly economic data preview -16 March 2009


Is the US Fed any closer to buying treasuries?

The Bank of England was the first among the world’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 ‘prepared’ 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.


􀂄 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 £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 BoE’s balance sheet and swings in indicators of money and credit growth to asses the success of the BoE’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 £26.1bn, more than double the cumulative cash requirement one year ago.


􀂄 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 ‘prepared to purchase longer-term Treasury securities rather than ‘studying’ 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).


􀂄 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 Trichet’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.

Kenneth Broux, Economist


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


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