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Tuesday September 5, 2006 - 01:12:29 GMT
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Economics Weekly: Bond yields fall, despite higher interest rates and faster inflation

Can the fall in bond market yields be sustained?
Even though short term interest rates have been raised in the UK, US and eurozone in the last few months, as a result of higher than expected price inflation, bond yields are falling. What is going on? In this briefing, we take a look at the US and UK bond markets for clues about what factors might be driving this trend.

A number of explanations spring to mind for the fall…
On one level, lower long term bond yields may be explained by the rise in official short term interest rates. If the rise in interest rates is felt to be sufficient to lead to weaker economic growth, this will eventually result in weaker inflation and so a fall in bond yields. That can be interpreted as an expectation that future short term interest rates will be lower than at present as a result of falling future inflation, the latter stemming from the braking effect on the economy from the current rise in short term rates. Moreover, the payout on any fixed income asset will be higher in the future in ‘real terms’, i.e. inflation adjusted, if price inflation is lower. If this were expected to be the case, that too would mean a rise in price and so a fall in yields, just as we are seeing at the moment.

The question then is, have expectations of future inflation fallen back and have short term interest rates peaked? That is a much more difficult question to answer and where the puzzle begins because the evidence does not appear to us to conclusively suggest that financial markets actually believe that interest rates have peaked and are still worried about future price inflation.

…but are they convincing?
Business investment is strong and if consumer spending does not slow down in the US then core consumer price inflation is likely to continue rising and force the US central bank to resume hiking interest rates. Moreover, the financial market perception embedded in the yield curve is that negative effects from a slower US housing market will lead to a weaker economy and so to lower price inflation. But the recent fall in long bond yields makes this less likely as the cost of mortgage borrowing falls and funds for spending can be released by fixing at lower rates. Moreover, business investment is strong in the US and seems to be for expanding industrial capacity rather than raising efficiency, as capacity utilisation is above average levels, implying a belief that domestic demand is likely to remain strong. Despite the profit-sapping rise in oil prices, US companies are still cash rich and have paid down debt in the last few years, leaving scope for the increased investment that we have been seeing. This might mean that despite some slowdown in consumer spending, the effect on the whole economy is softened by growth in the 10% of it that is due to investment spending, at least for long enough to persuade consumers to continue spending.

Much of the above arguments about the US apply to the UK as well, but perhaps even more powerfully.
Forecasts (August consensus) for UK economic growth next year centre on 2.4%, only a bit below this year’s expected 2.5%. However, in the US the expected slowdown in growth for 2007 is sharp, put at 2.7% from 3.4% this year. For inflation, the UK is expected to see a deceleration from 2.2% this year to 2.1% in 2007, admittedly still low inflation rates. For the US, consumer price inflation is expected to decline sharply, from 3.8% this year to 2.6%.

The financial market is sending mixed signals…
Market implied inflation expectations, based on conventional bond yields minus index linked, are shown in chart b. For the UK, they show that inflation expectations are still high. For the US, they show that there has been some fall back since the peak earlier in 2006. To some extent, therefore, the fall in US yields might seem more justified than the fall in the UK’s. Of course, we also know that some two-thirds of the change in the UK bond market can be explained by changes in the US bond market, so the fall in UK bond yields may be more down to the US rather than domestic UK events. With a further rise in UK short term interest rates expected in the autumn, amid growing evidence of a stronger housing market, it would otherwise be very odd that UK long term bond yields have fallen so much in recent weeks and to below where they were before the August rate hike.

…and real interest rates suggest that growth will not slow for long and could accelerate
What about real interest rates? If financial markets are predicting a recession, as implied by the downward sloping yield curve, then we would expect inflation expectations to be falling and real interest rates to be high. However, chart c and d shows that this is not the case for the latter at all. Average long term real interest rates in the US are 2%; the current rate is about 1½%, well below the long run average. For the UK, the long run average real interest rate is just above 2% and the current rate is also about 1½%. What both charts show is that at these levels economic growth usually accelerates not decelerates and economic growth certainly does not enter recession territory. In other words, financial market expectations of the extent of slowdown in US and UK economic growth in 2007 may be disappointed. At no time in the last three decades has the US economy experienced recession with real interest rates at these levels. The same is true of the UK, see charts.

…and our calculations show that bond yields could end substantially higher if inflation does not slow as expected
We have estimated where bond yields should be based purely on the evolution of short term interest rates and inflation, which together explain more than 80% of the variation in the 10 year rate. Charts e and f show that in the past 27 years or so our estimated rate has not been to far from the actual, except at times of extreme stress, usually around recession episodes. On this basis, US 10-year yields should be around 6.7%, against the current rate of 4.8% and for the UK, 5.5%, against the current (August) yield of 4.6%. Even allowing for lower inflation expectations, this seems a very large gap and offers the potential for severe market volatility if events do not unfold the way that bond markets are expecting them to and increasingly pricing for.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
Switchboard:
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