Despite rising supply, global bond yields still fall
Tue, Mar 17 2009, 06:01 GMT
by Trevor Williams
As the Bank of England embarks on a £150bn programme of buying securities from the private sector that will not be financed by an equivalent issue of government paper - so called quantitative easing – bond yields are falling around the world. This is perhaps partly because of a perception that others around the world may also join the UK central bank in purchasing government debt, although there is no convincing evidence yet to support such a view. Indeed, the most likely reason for what is a coordinated fall in global yields could simply be the fact that the economic data flow in the last few weeks has been very poor for most countries. Admittedly, government bond yields in the UK have fallen more sharply than most this week, owing to the start of quantitative easing by the Bank of England, see chart a. This has left UK 10 year gilts yielding just under 3%, below the equivalent German government bond for the first time in seven years, though still above the US 10 year treasury.
Of the £150bn of unfunded debt purchases planned by the Bank of England, £100bn will be spent on UK government gilts, or roughly equivalent to one third of the entire stock of conventional gilts at end 2008. (Quantitative easing has all sorts of other implications for financial markets and we will consider some of these in a future article). However, our focus is not on the UK gilt market alone but on the general decline in major developed country government bond yields that has occurred in the last few weeks. What appears to be the best explanation for this and what does it mean for the shape of the yield curve in the months ahead and prospects for economic recovery.
Weaker economic growth and falling inflation explain sudden dip in government bond yields around the world…
Calculations suggest that net new debt issuance by governments around the world will be of the order of $3trillion in 2009, after $1trillion in 2008. This may not come as a surprise to many and, in fact, could even be an underestimate, since new spending initiatives are being announced seemingly every week. Hence, no one is sure what the total liability of the many packages to counter the threat of deflation, of bank and financial market firm rescues and to boost economic growth will mean for government spending until after the year is out. What is sure however, is that it will entail a significant rise in debt issuance to fund this spending increase. A rise in bond supply should mean a fall in global bond prices and therefore mean a rise in yields but bond yields are falling, i.e. prices are rising. Part of the explanation is that the collapse in so many asset markets (equities, property, commodities etc) around the world is making government bonds the safest place to put investment flows, so encouraging buying of government debt.
Charts b, c and d show that the reason why bond yields have fallen is that there has been a steep dive into recession in the US, UK and Euro area economies in the last quarter of 2008. Further, the flow of economic data so far in Q1 suggests that this recession has deepened rather than eased. And the reason why a fall in nominal yields is entirely sensible is that without it, real yields would have risen given a fall in current consumer price inflation. This would mean a rise in the cost of borrowing at a time of worsening recessionary conditions and so would be inimical to economic recovery. We have calculated a measure of ‘real’ bond yields by deflating nominal 10 year government bond yields in the US, UK and euro area with consumer price inflation for the relevant time period.
The result of this analysis shows that real bond yields would be rising quickly and be significantly higher than in the last few months. Fortunately, forward looking inflation expectations derived from index-linked gilts show that inflation expectations are falling, see chart e. The reason is shown in chart f, which is that consumer price inflation is falling very sharply and so 10 year ahead inflation expectations in the bond markets have fallen back. This means that the ingredients for economic recovery are still in place. This in turn implies that bond yields further out along the maturity curve, 2 years to 10 years and beyond will be low and flatter than otherwise in the months ahead. This is something that governments want to see to encourage economic recovery through a lower cost of borrowing for companies and households at a time of rising unemployment. A change to this mix of low inflation expectations and low bond yields is unlikely to occur until economic recovery looks like a real prospect.
