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Economics Weekly: The end of the bond market 'conundrum'?The end of the bond market 'conundrum'?
Are bond markets finally getting the message that economic growth is accelerating?
Last year, former Fed Chairman Greenspan famously referred to a 'conundrum' in bond markets whereby long dated yields were still falling even though the central bank was raising short term interest rates. Many viewed the resultant downward sloping yield curve as a sign that there would be recession in the US, if the central bank kept raising interest rates. In the event, proof that the central bank was right can be found in the fact that Fed funds are now at 4.75% and yet the economy continues to grow rapidly.
True, there are few signs of significant inflation pressure in the US (underlying inflation was 1.8% in the year to February), or indeed around the world, but that has probably been down partly to the pre-emptive action of the Fed and other central banks in raising interest rates. This has helped to keep down price and wage inflation expectations and hence inflation itself. In this briefing, we take a look at where long term bond yields could go in the US and UK now that they are finally rising.
World economic growth is very strongâ€¦
For the first time in 15 years, the wordâ€™s three main central banks are either raising short term interest rates or are about to (US, euro and Japan). Last week, the IMF raised its forecast for world growth from 4.3% to 4.9%, highlighting that this would be fourth consecutive year of 4% plus annual growth. This is the reason for higher global short term interest rates â€“ excess global capacity is rapidly being used up and inflation is under upward pressure. Solid growth prospects are driving stock market recoveries around the world and commodity prices are setting record or decade highs.
â€¦and so long term market rates are rising as short term official rates move up
In this environment, it is difficult to explain why bond yields are not even higher than they are currently, see chart a. But US 10 year yields are now at their highest level since the central bank started hiking short term rates in June 2004. The yield on the 10-year Treasury was just under 5% in the week just ended. Although lower, UK rates have risen to six month highs in the past week or so. UK bond yields do remain remarkably sanguine at 4.4%, but economic growth is weaker than it is in the US and UK consumer price inflation is currently 2% (for February), spot on the official target. European 10-year yields have risen sharply this year and are now just under 4%. Purchasing Managers Indices (PMIs) are suggesting that with energy prices higher and demand growth picking up, the pressure on firms to pass on cost increases is intense and it is becoming easier for them to do so. Recent PMI surveys of the US, Europe and UK have all shown a rise in prices charged, suggesting some success in passing on price increases and so adding to inflation risks. In other words, bond markets are coming under increasing selling pressure, see chart a. How high can bond yields go?
This should be seen as part of a normal response to the economic cycle
We have calculated where 10-year bond yields in the US and UK would be based on the current level of interest rates and the rate of consumer price inflation, see charts b and c. For the UK, the projected bond rate is 5.5% against the current rate of 4.4%. For the US, the projected rate is 5.25% against 4.90% at present. Current US 10-year bond yields are therefore much closer to reflecting long term valuations - just some 40 basis points off where they should be to according to historical links with short interest rates and price inflation. Many would argue, however, that this link is no longer valid, as inflation will remain low due to more proactive central bank action to combat price rises and globalisation, which is keeping down world inflation. For the UK, there is much more scope for a sharper correction since the current 10- year yield is some 110 basis points below where the model would suggest. Some of this might be reflecting the strong demand amongst UK pension funds for longer dated securities to match their pension obligations.
Conclusion - bond yields are likely to rise further
These calculations give us one broad measure of the scope for further corrections in bond prices this year. The good news is that a move up in yields would only be in line with a normal economic cycle, where strengthening activity leads to increased inflation pressure and higher interest rates from the central banks, and not an inflation scare. Should there be a scare about inflation, however, then bond prices could fall much further and yields could head towards 6%.
* All charts are sourced Lloyds TSB FMD Economic Research & datastream
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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