Monday January 30, 2006 - 11:17:05 GMT
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Are current UK bond yields sustainable?
Economics Weekly: Are current UK bond yields sustainable?
Are UK government bonds overvalued?
Government bond yields have been falling in all of the major economies in the last few years, so it is a global rather than just a UK phenomenon, see chart a. But it is the case that historically UK yields have usually been higher than those in the US and euro area. This has been because of a higher perceived risk from inflation. However in the last year, the UK fixed income market has decoupled from the US and, although its yields are still above those in the EU, they are well below those in the US. What explains this?
Global bond yields are down...
First, it is worth noting that UK real long term interest rates have fallen sharply, so the risk premium attached to UK bonds has dropped. But this is the case globally as well. It is in the 30 and 50 year debt maturity range that UK rates are particularly low even by global standards, at less than Â½%, but it is also an area of the curve where there are issues of low supply and official rules about funding long term liabilities that encourage pension funds to hold assets that are very highly priced.
A number of factors could lie behind the fall in global real yields; a rise in global savings; a rise in risk aversion that make investors buy more index linked bonds; a fall in actual and expected inflation and a rise in holdings of bonds to fund a rise in pensions (a demographic effect). But what is striking is that our calculations suggest that these factors do not fully explain why real bond yields are as low as they are currently. Moreover, there is evidence real yields tend to revert to the long run mean value -i.e. mean reversion - implying that there could be a rise in the near future or at least that the next big move could be up rather than down.
...but even so long term UK yields are very low...
One way of trying to assess value in the UK bond market is look at the experience of the US and the euro area. Since there is a shortage of data to compare the real yields in these markets with those in the UK, we will focus on the 10-year government benchmark bond yield. The US is not only the worldâ€™s largest economy but also has the worldâ€™s largest and most liquid bond markets, so usually US long term interest rates dominate movements in other bond markets. But our statistical analysis suggests that European markets are more optimistic than their US counterparts. One way of measuring the extent of this effect is to look at how the US 10y benchmark bond yield correlates with other markets, see table 1, and then to look at the direction of causality also shown in the table, over periods of 25 and 5 years.
The US bond market does not set the global bond market trend as much as before...
Table 1 shows that the UK bond market is 0.92 correlated (a perfect match is 1) with the US over a 25 year period, with the eurozone countries at 0.86. Admittedly, this has fallen in the last few years, as the single currency made it easier for EU countries to trade in what was now a much bigger â€˜domesticâ€™ bond market so insulating it from US trends. Hence, the UK is now more linked to the EU market than previously. However, the movements in the UK 10y bond markets are still linked 79% of the time with the US and 75% of the time with the euro area.
...but it is still dominant...
But what about causality? The US leads and the others follow is the brief answer. 84% of the variation in the change in UK bond yields is explained by changes in US bond markets. However, that still leaves a 16% variation that is due to other factors, which would include the EU bond market and UK domestic events. For the eurozone, 73% of the variation in its market is explained by the US. Since the inception of the euro, this has fallen to 56% of the variation in euro 10y bond yields. For the UK, too, there has been some decline, to just 62% of the 10y bond market variation being explained by shifts in the US market. Global investment trends - more instruments, more markets - have also lessened the explanatory power of the US bond market, but it remains by far the best single variable. What does its recent trend suggest?
...and this link suggests that the UK and European bond markets are highly priced
Charts b and c confirm that the UK and EU markets are overvalued, relative to their historical relationship with the US, to a greater extent than any time since the LTCM and Russian bond market crises of 1998/99. For the UK, the historical link suggests that bonds are 127 basis points lower than would be expected and for the EU that the benchmark bond is 144 basis point overvalued. Finally, even without the US relationship with the UK market suggesting that its bonds are overvalued, the UK market, based on its own historical performance, is showing that 10y bonds are expensive, by some 60 basis points, see chart d. Whether this means that UK bond markets are about to correct imminently is impossible to say, but we are sceptical that they are offering sustainable long run value. One estimate suggests that the real long bond yield in the UK is close to its 300 year lows â€“ how sustainable is that?
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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