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Tuesday August 30, 2005 - 10:14:24 GMT
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How long can bond yields defy gravity?

Economics Weekly: Economic Research and Analysis: How long can bond yields defy gravity?

Bonds are bid
In the last few months, there has been a sharp rise in equities but also a sharp rise in bond prices (bond yields have therefore fallen). Equity markets clearly feel that corporate profits will continue to grow and that earnings will either hold up or rise. Bond markets are looking for weaker economic growth, and hence lower inflation. Who is right? Time will tell. In this analysis, we are more interested in the extent to which bonds may be under or overvalued. There are a number of ways of calculating the value of a bond in order to assess whether it is 'fair'. Our view is that the long run value of a nominal bond yield is driven by the risk premium financial markets place on that bond and by these marketsí long run inflation expectations. We have therefore calculated fair value by taking inflation adjusted 10 year bond yields (or the risk premium) and forecasts of 10 year inflation rates for the US, UK and Germany.

Consider recent events in financial markets...
Real bond yields in the UK have fallen to near record lows, see chart A. Some of the fall in the UK bond market's risk premium or real yield may be explained by the fall in the US and other major global bond markets, all of which may be reacting to the risk to growth of the high price of oil, and have also fallen to very low levels in real terms as future inflation is marked down. With global goods prices being kept down by competition from China, global open markets that allow this to happen, and by perceptions that central banks will keep inflation low serving to anchor price expectations, it appears that bond markets are sanguine about the effects of high oil prices on inflation.

But equity market are clearly being buoyed by a healthy rise in corporate earnings and by continued economic growth in the US, China, the UK and signs of recovery in Japan and the euro zone economies. However, bond markets are ignoring these signals and concentrating on the low inflation message from higher oil prices slowing growth. In the long run, both cannot be right.

...have risk premiums fallen?
After widening earlier in the year, the spread between government bonds and corporate bonds is narrowing again, see chart B, suggesting a search for yield and greater confidence that inflation rates will remain low and company earnings growth will be maintained (as shown by the equity price surge). One interesting question is the extent to which low bond yields are helping to drive economic growth forward by keeping the cost of capital and consumer borrowing cheap, particularly in the US and possibly China. It is very clear that one of the reasons why economic growth globally remains robust is because interest rates, nominal and real, are low (so monetary policy is loose). That is perhaps one reason why global liquidity is so plentiful and investors are searching for higher returns in an increasingly global capital market where returns are low.

Worrying trends for bonds are being ignored
The fall in bond yields has come despite record debt issuance by government around the world, including the US, euro area and Japan. World economic growth last year was the fastest in 30 years, yet bond yields in 2005 are now nearly as low as they were then. Chart A seems to suggest that part of the explanation for this is that the risk premium demanded by bond investors has fallen (it may also have fallen in equity markets, which is why prices are higher alongside the rise in bond prices). Certainly, the fact that spendthrift governments are not being asked to pay more for issuing bonds is perhaps a sign that global saving may indeed be pushing down risk premiums and so yields to levels that are not reflecting a realistic real risk of lending.

In addition, countries with large current deficits like the US are not being asked to pay more for their bond issuance either, which is also odd since the currency could fall and so inflation and interest rates rise. What is going on?

Global liquidity is high
The simplest answer appears that global capital markets are awash with liquidity, perhaps partly due to low interest rates in the US and elsewhere, like China. Also, global savings seem higher than desired global investment intentions at present, so investment in securities is quite strong. Add to the mix a desire on the part of Asian central banks to keep down their currencies against the US dollar and a willingness to use the build up in their foreign exchange reserves from the large current account surpluses they are accumulating to buy US securities to do so, and a convincing explanation for low global bond yields begins to appear.

The answer to the question how long can bonds defy gravity is: for a while longer yet. Our chart of fair value for the UK, US and Germany markets implies that bond yields could actually fall further in the months ahead, see chart C on the front page. The fall could be 40 basis points in the UK (to 4%), 20 in the US (to 3.9%) and 20 in Germany (to 3.14%).

A correction may not occur until US interest rates are significantly higher (and it is possible that their yield curve may invert before any correction occurs). But one thing is for sure in financial markets; there will be a correction one day. The longer it takes to occur, the more dramatic it is likely to be.

UK economic indicators
UK data this week are few, but attention will be on the consumer credit and confidence figures for clues about how consumers are reacting to recent events, like the cut in interest rates and the rise in oil prices. The manufacturing PMI data could help to see whether the industry continued to recover in Q3, as the Q2 data suggested that output was no longer falling as sharply.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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