Benchmark government borrowing costs in the bond market have climbed since the middle of the year, after several years of relentless decline. As a paid-up member of the “Price-Is-Knowledge” club, I’m intrigued about the signal bond yields are trying to send.
Ten-year yields have been heading south for most of this decade, with German borrowing costs dipping below zero for the first time just before the middle of this year:
Since the end of June, however, yields have risen by more than 30 basis points. That isn’t exactly a market rout, especially given the exceptionally low starting point; the trajectory is shallow, and markets are moving pretty much in lockstep. But it might be the start of a trend reversal:
Against a particularly unsettled political and economic backdrop, it’s even harder than usual to read the signals emitted by interest rates. In this case, though, there are three possible interpretations — which aren’t necessarily incompatible — of the meaning of higher borrowing costs in the fixed-income market.
It’s the Election, Stupid
Polls suggest the US presidential election is now too close to call. After the surprising results of the Brexit referendum in June and last year’s election, UK voters may be reluctant to reveal their true intentions, undermining trust in polling as a guide to outcomes. That argument suggests that Donald Trump’s true support may not be showing up in polling.
Trump’s unconventional approach to policymaking is unlikely to be welcomed by investors. On Nov. 1, 370 economists released a letter accusing him of favouring “magical thinking and conspiracy theories over sober assessments of feasible economic policy options.”
As a result, the rise in the 10-year Treasury yield to about 1.8 per cent from as low as 1.36 per cent at the start of July could be evidence that fund managers are demanding higher compensation as a bulwark against a Trump victory. The recent decline in global stock markets reinforces the possibility that the smart money is moving to the sidelines until the election is decided.
It’s the Economy, Stupid
The prospect of higher inflation, which erodes future bond income, typically drives yields higher. And consumer prices are finally showing signs of life — Japan is a notable exception — after months of stagnation:
Again, price gains are stirring from very low levels. But the consensus among economists is for US inflation to surpass the Fed’s target in every quarter of next year. The UK is likely to show average consumer price increases of 2.3 per cent next year, and even Eurozone inflation is expected to average 1.3 per cent in 2017, compared with just 0.2 per cent for this year.
So it’s plausible that bonds are simply responding to a change in economic fundamentals by discounting an acceleration in inflation in the quarters ahead. For the sake of our pensions, we should hope that the record-low yield environment turns out to be an anomaly.
Changing tack
The European Central Bank is still in the market, with purchases of 80 billion euros ($90 billion) of bonds each month. But there’s increasing speculation that the ECB will soon taper its purchases to reflect a reduction in the risk of deflation. On Wednesday, for example, the German Council of Economic Advisers said the current policy “threatens financial stability” and “the ECB should slow down its bond purchases and end them earlier.”
The Federal Reserve, meantime, appears poised for its second interest-rate increase in more than a decade. Prices in the futures market point to a chance of about 70 per cent chance of a hike on the December anniversary of last year’s increase. In the U.K, the chances of a second rate cut in December, after August’s post-Brexit easing, have dropped to 7 per cent from 40 per cent just seven weeks ago.
No wonder the universe of bonds that yield less than zero is starting to shrink. According to the calculations of my Bloomberg colleague Phil Kuntz, the market value of negative-yielding bonds around the world has dropped to $9.8 trillion — still a huge amount, but down 19 per cent from June’s $12.2 trillion peak:
Bond markets face the prospect of being slowly but surely unhooked from the life-support machine of inexhaustible central bank liquidity. This could take the form of less quantitative easing or the end of ultra-relaxed monetary policies.
“When the facts change, I change my mind. What do you do, sir?” John Maynard Keynes reputedly said. Bond markets suggest that the facts have changed; How they’ve performed in recent months may end up being less important than the reasons for the shift.
