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Forex Market News - Economics Weekly: Global bond yields are rising, but will be limited by ample liquidity and low 'risk premium'

Economics Weekly:

Global bond yields are rising, but will be limited by ample liquidity and low 'risk premium'

Overview
In recent weeks, global 10 year bond yields have suddenly started to rise. After many months of ignoring the message from strongly rising equity markets and data showing higher inflation and faster economic growth, these markets have begun to price for increased risk. This is not a matter for surprise; the real surprise is that it has taken so long for this to happen. There is, however, also a question about how high bond yields will rise. We attempt to answer this by looking at one measure of bond investor's risk premium and also by taking into account financial market's inflation expectations to see whether bond yields are currently expensive or cheap. This research suggests that the rise in bond yields will be fairly limited because of plentiful global liquidity and a still low risk premium, which will limit the downside for bond prices and so the upside for yields. One global feature of bond markets though, is that yield curves remain inverted, as the rise in yields has been similar across different maturities. However, we shall not focus on this but on 10 year yields.

Bond prices are falling as investors worry about faster economic growth and higher inflation…
Bond yields are now mostly approaching their 2004 highs, see chart a. Why is this? One reason is that fears about weaker economic growth has proved unfounded, as the strength of the rise in equities testifies, see chart b. Corporate profits are holding up very well and company pricing power – firms ability to push through price increases on to consumers – has increased. This along with buoyant acquisition and mergers activity has supported equity prices and it would have been very strange had there not been some fall in bond prices and hence a rise in yields. In addition to faster economic growth and record, or near record, highs in equity markets, there has also been a rise in price inflation, see chart c, albeit from a low base. This is reflected in a rise in inflation expectations amongst financial market investors. In the UK, see chart d, inflation expectations are at their highest level since 2000. For the US, see chart e, and the eurozone, see chart f, inflation expectations are off their lows but are only back to levels seen in 2006. This is resulting in UK bond yields being higher than those in the US or eurozone, but we also have to consider risk premiums in these markets.

...and risk premiums for holding bonds seem to be higher, but not excessively, held back by ample liquidity
One measure of market perceptions of risk is the index linked bond yield, because it excludes inflation and is close to views about some long run desired rate of return. Comparing real economic growth with this yield should therefore give us a picture of the expected real return or risk premium relative to actual experience. Chart g shows that in the UK, the expected real return is above gdp growth, implying upward pressure on the real yield. (This compares with previous months where this rate was very low and so put downward pressure on UK bond yields). This is also the case for the euro area, with real growth above the 'risk premium' see chart i, explaining the rise in bond yields recently, but not for the US, see chart h, where the real risk premium has fallen recently in line with growth. In the case of all of these economies though, we need to take into account price inflation expectations in order to properly compare current bond yields with that implied by market based valuations of 'fair' value.

Current bonds yields offer a return above the 'risk free' or fair value rate
Adding inflation expectations to the index linked rate of return for the US, UK and euro zone gives us a figure for the total rate of return expected from holding these bonds at a risk free rate or ‘fair value’. The results are shown in chart j, where we have subtracted the current bond yield from the risk free rate . A positive gap implies that actual bond yields could rise and a negative gap that bond yields could fall or that there is a premium demanded for holding bonds. The results rather surprisingly suggest that currently bond yields are offering a return above the risk free rate. In other words, bond investors are getting a higher return from holding bonds compared with the rate implied by summing the index linked yield plus their expectations of inflation in ten years' time. This can be interpreted as implying that perhaps the risk premium element of the risk free rate or inflation expectations are too low. Of course, it could also be that a high level of global liquidity is holding down global risk premiums. The analysis suggests that bond yields may not rise too much further from current levels, unless inflation expectations rise further or global liquidity declines and pushes up the risk premium for holding fixed income instruments.
Trevor Williams, Chief Economist

Weekly economic data preview

Interest rate decisions in the UK, US and euro zone - only UK set to move

• The BoE is expected to hike Bank rate by 0.25% to 5.5% on Thursday. The accompanying statement should offer some clues about the prospect of further tightening ahead. The risk of no change in Bank rate is considered very small and would elicit significant market reaction, especially with all the market forecasters polled unanimously predicting a 0.25% hike. We also believe the risk of one or more members of the MPC voting for a 0.5% hike in May is high.

• Financial market forecasters are also unanimous in predicting no change in interest rates in the US on Wednesday and the euro zone on Thursday. While we agree with this view, our projections for the remainder of the year differ from the current market consensus. We maintain our long-standing view that interest rates will not be cut in the US and expect one or possibly two more hikes from the ECB (the first in June), with respective interest rates ending 2007 at 5.25% and 4.25%.

• Economic data from the euro zone has remained buoyant, notably the German IFO survey and EU- 13 money supply accelerating to a 24 year high of 10.9%. This has firmed expectations that the ECB will hike interest rates to 4% in June. Given the clarity provided by the ECB since it started tightening policy in December 2005, a clear signal of intent is expected from president Trichet at the press conference. We expect to hear 'strong vigilance' or something akin to this in his opening remarks.

• It is a relatively quiet start to the week for key economic data but the few are likely to be overshadowed by official interest rate decisions. The US trade balance, on Thursday, is perhaps the main highlight but US retail sales and producer prices on Friday will elicit strong market reaction. In the UK, another disappointing performance by the manufacturing sector in March would raise doubts about a rate rise ahead of the decision on Thursday, but we are looking for a firm rebound in output.


Financial markets are very confident that base rate in the UK will be increased by 0.25% to 5.5% on Thursday. While we agree with this view, we also believe that the risk of a surprise, no rate change or a 0.5% hike, should not entirely be ruled out, especially given the disregard shown by the Bank of England MPC in the recent past for market expectations ahead of its interest rate meetings. The minutes of the April MPC meeting showed a 7-2 vote in favour of holding Bank rate steady at 5.25%, with the two dissenters (Besley and Sentance) advocating an immediate 0.25% hike. However, the text of the minutes suggested that there were three broad camps within the MPC, with the majority content to keep base rate at 5.25%, but concerned however that the balance of risks for inflation were to the upside in the medium-term. This may be the most crucial point, given that the MPC were unaware at that time that annual CPI inflation had breached the key 3% level in March, forcing the BoE governor to pen an explanatory letter to the chancellor. Hawkish comments from BoE governor King since, stressing the need to anchor inflation expectations and to do whatever was necessary to reach the CPI target, suggest that there should be no surprises on Thursday and that a rate hike is on the cards. It would not be a major surprise if one or more members of the MPC voted for an immediate 0.5% increase.

With an interest rate hike this week considered long odds-on, financial markets will be mainly on alert for any clues about the scope for further hikes in the months ahead. To this end, the accompanying statement to the rate change this week will be closely inspected and could elicit strong market reaction. We remain of the view that interest rates may peak at 5.5% in this tightening cycle, with the need for further hikes still unclear and data dependent. The BoE Inflation Report, published on May 16, and inflation and earnings data in the months ahead must be watched closely. Data this week is bunched ahead of the interest rate decision. The weakness in manufacturing output data has contrasted with survey evidence and a rebound is forecast in March. The trade deficit may have widened in March on higher imports.

Although no changes in official interest rates are expected this week in the US or euro zone, the press statements could spark strong market reaction should the language used or tone not meet with current market expectations. The risks we believe are skewed in opposite directions - that the ECB is not hawkish enough about the outlook for higher interest rates in the months ahead and the US Fed retreats from its slightly hawkish stance after the recent batch of softer data. Economic data in the US are likely to attract most market attention this week. The US trade deficit unexpectedly narrowed for a second consecutive month in February, but may have widened back above $60bn in March on higher oil imports. Retail sales data on Friday will be closely watched to see if consumer spending started the second quarter on a solid footing.
Jeavon Lolay, Senior Economist

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