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Wednesday June 21, 2006 - 16:16:32 GMT
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What does the 'Fed model' tell us about bond yields?

Recent safe-haven flows have led to a fall in yields at the long end of the curve
Government bond yields have edged lower in recent weeks as equity prices declined, suggesting that markets may have become slightly more concerned about economic growth prospects. However, the fall in yields have tended to be more at the long end of the curve, such as 10-year yields, rather than the short end. In other words, yield curves have generally flattened. Markets have become increasingly uncomfortable about the pricing of risk which implicitly assumed a continuation of strong economic growth, low inflation and hence high real returns. Thus, it seems that safe-haven flows into bonds have suppressed yields particularly at the long end. In the past week, some signs of stabilisation in equities have led to a backup in bond yields.

At the short end, yields have not fallen by as much and this reflects the ongoing trend in global monetary tightening. The US Federal Reserve looks likely to raise interest rates at the June 28-29 meeting. It has voiced its concerns about inflation risks with US CPI inflation heading above 4% on the year-on-year comparison. This has supported yields at the short end.

In Europe, the European Central Bank is expected to continue to raise interest rates this year with EU-12 CPI inflation currently well above the 2% target and M3 money supply continuing to signal excess liquidity in the economy. In the UK, the Bank of England is expected to raise interest rates by 25bps this year with CPI inflation expected to rise further above target during the summer (currently 2.2% for May), though core CPI remains well below 2%.

Notwithstanding the difference in the yields at the short and long end of the curve, the general decline in yields since mid-May poses the question again whether bond yields are still too low, i.e. whether bonds are expensive.

Are yields too low?
We posed a similar question a few weeks back in the Economics Weekly (“The end of the bond market conundrum?”, 10 April 2006). At the time, UK 10-year bond yields were only 4.4% and US yields were 4.9%. Based on a model using interest rates and inflation data, we projected that the ‘fair value’ bond rate is 5.5% for the UK and 5.25% for the US. Hence, UK bond yields were more than 100bps below fair value and US yields were about 35bps below. In other words, bonds were expensive, particularly in the UK.

Bond yields have backed up in the past week on some signs of stabilisation in equities, but a degree of financial market volatility is likely to persist. Yields, however, remain below the recent May 12 highs, just before the recent equity market sell-off. US 10-year yields are currently 5.15% with UK yields at 4.72%, German yields at 4.00% and Japanese yields at 1.87%.

The Fed model - comparing bonds and equities
The Fed model is based on the idea that bonds and equities are competing assets and it compares bond yields with the earnings yield (inverse of the price-earnings ratio) on equities. The model is not without its critics and it was never formally endorsed by the US Federal Reserve but a Federal Reserve report to Congress in July 1997 suggested the bank was following it.

According to the model (or a variant of the model), if the ratio of bond yields to earnings yields falls below the long-term average, then this would suggest that bond yields are ‘too low’ compared with earnings yields, i.e. bonds are expensive relative to equities, and vice versa. To obtain the earnings yield data, we calculate trailing five-year price earnings ratios for the US, UK, Germany and Japan. Bond yields are based on benchmark 10-year cash yields.

They indicate that, for the US, the bond yield/earnings yield ratio has averaged 1.5 since 1984 - see Chart 1. The ratio soared to 2.3 in 2000, suggesting that bonds were cheap relative to equities, but fell to 0.8 in 2003 which indicated that bond yields were too low, caused by fears of deflation. It is currently at 1.4, suggesting that current bond yields are broadly fairly priced against equity yields.

For the UK, the bond yield/earnings yield ratio has averaged 1.3 since 1984 - see Chart 1. The ratio rocketed to 2.1 in Q3 1987, suggesting that equities were expensive relative to bonds, before the stock markets crashed. At the start of 2003, the ratio fell to only 0.6, suggesting that bond yields were too low. In 2006, it has risen to 0.9, still well below the 1.3 average, and suggests that bond yields need to rise to about 6.5% to raise the bond yield/earnings yield to the long-term average. But the 1990s saw a marked fall in UK inflation and it may be more appropriate to take the average bond yield/earnings yield ratio from 1992 which would suggest that bond yields need to rise to 6% rather than 6.5%. If we take the average from 1997, when the Bank of England was made independent, hence improving monetary policy credibility, the bond yield/earnings yield ratio has averaged only 1.0, suggesting that the current bond yield may not be substantially too low after all.

In the euro area, the bond yield/earnings yield ratio has averaged 1.2 since 1984 - see Chart 2. The ratio is currently only 0.7, well below the long-term average and suggests that bond yields are still too low. Perhaps the weak economic growth in the euro area economy in recent years has led to permanently lower bond yields. In the past five years, the bond yield/earnings yield ratio has averaged only 0.6 which is in line with the current figure.
In Japan, the bond yield/earnings yield ratio has averaged 1.7 since 1984 - see Chart 2. The ratio is currently only 0.9 which suggests that bond yields are too low. However, the country has been battling against deflation in recent years and official interest rates remain at zero. The bond yield/earnings yield average since 1995 has in fact averaged 0.9 which is bang in line with the current figure.

Overall, of the four economies we have analysed, it suggests that US bonds are broadly fairly priced compared with equities (but yields could still be higher), UK bond yields are too low and German/Japanese bond yields are far too low. However, this is based on average bond yield/earnings yield ratios since 1984. Arguably, structural changes in some of economies indicate that current bond yields may only be slightly too low.

Hann-Ju Ho
Senior 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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