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Recent falls in bond prices, and rises in yields, may not signal the end of low
interest rates
Dec 3rd 2016
THE death of the long bull market in bonds has been called many times in recent
years. Such a consummation is devoutly wished for by those who think the global
economy will never get back to health until short- and long-term interest rates
return to more normal levels.
Following the election of Donald Trump as American president, the funeral rites
are being read again. The yield on the ten-year Treasury bond jumped from 1.73%
(while the votes were being counted) to 2.36% at one stage; the yield on the
two-year bond rose from 0.78% to 1.12%. (Bond prices fall as yields rise.)
The rationale for the shift is the belief that Mr Trump will push through a
fiscal stimulus, in the form of tax cuts and infrastructure spending. Not only
will that boost the American economy but it will allow the Federal Reserve to
return monetary policy to more normal levels by pushing up rates from the
current 0.5%. It could also lead to higher inflation in the medium term.
Forecasts for American inflation in the early 2020s can be derived from the
bond market. In July, they pointed to 1.4%; now they imply 2.1%. All three
factors faster growth, rising short-term rates and higher inflation are usually
drivers of higher bond yields.
In the course of 2016, moreover, fears of deflation and a sharp slowdown in the
Chinese economy have steadily faded. As a result, it seems less and less likely
that investors would want to own government bonds, especially as trillions of
dollars-worth have been offering negative yields.
Nevertheless, this bond-market sell-off needs to be set in context. During the
taper tantrum of 2013, when the Fed signalled a slowing of its
quantitative-easing programme, the ten-year yield reached 3%. It was as high as
2.47% in June last year.
Moreover, other bond markets have not been as seriously affected by Mr Trump s
election (see chart). In Germany, ten-year yields may no longer be negative but
they are still just 0.2%. Indeed, the gap between German and American ten-year
yields is at its widest since the 1980s. British yields are around where they
were at the time of the Brexit vote but well below their level in January. In
Japan the yield on the ten-year bond is still close to the central bank s
target of zero.
Continued bond purchases by central banks are one reason why yields may not
rise that far in Europe and Japan. What is more, pension funds and insurance
companies will continue to be ready bond buyers at almost any yield level as
they seek to meet regulatory requirements or to match their long-term
liabilities.
Furthermore, it is not clear how much of Mr Trump s programme will be
implemented, nor indeed whether economic growth or inflation will actually
rebound. The factors affecting inflation are long-term: globalisation,
deregulation and automation, says David Lloyd of M&G, a fund-management group.
In addition, a rise in bond yields may play a part in choking off economic
growth. The ratio of total debt (governments and private sector combined) to
GDP has risen in both developed and developing economies since the 2008 crisis.
A large stock of debt needs a low interest rate to make it tolerable, says
Mike Amey of PIMCO, a fund-management group.
And if 2016 has taught investors anything, it is to take account of political
risk. In the past, this was a factor that bond investors in developed countries
rarely had to worry about. For a long time, politicians in the Western world
have been dancing round the same handbag, says Mr Lloyd. The policy
differences have been largely rhetorical.
The rise of extremist politicians brings with it the risk of extreme outcomes.
The problem for investors is that the implications of such shocks are not
uniform. The Brexit vote was followed by a fall in bond yields (as cautious
investors opted for the safety of bonds), but the election of Mr Trump caused
yields to rise. Had the president-elect made a swift promise to pursue his
protectionist agenda, however, bond yields might have fallen, since a tariff
war would hurt economic growth. The election of Marine Le Pen as French
president would probably cause European government bonds to sell off; yields in
America and Japan might fall.
The biggest problem for investors is that ultra-low yields leave so little
margin for error the likely annual return on most long-dated bonds can be wiped
out in an afternoon s trading. Government bonds may still find ready buyers,
but they won t sleep as soundly as they used to.