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The yin and yang of yields

Fri, Jun 12 2009, 15:42 GMT
by UniCredit Research

UniCredit Group

The rapid rise in bond yields of the last few months signals a welcome normalization of inflation expectations, and not mounting fears of rampant inflation. As economic activity stabilizes and financial market stress drops back to pre-Lehman levels, inflation expectations of about 2% should come as a relief to both investors and central bankers. Markets however have over-reacted, and are pricing an unrealistically prompt tightening of monetary policy in both the US and Europe. I believe both the Fed and the ECB will remain on hold for another twelve months, but it will be an anxious wait, and bond markets are in for a rough and bumpy ride. The short end of the curve looks most vulnerable to both an early correction and higher volatility; the long-end will correct further as markets take a more sober view of the recovery, but supply concerns will keep a solid floor under longterm yields. Indeed, I remain convinced that the definition of an exit strategy is most urgently needed on fiscal policy. This weekend’s G8 might set the stage, but we need to see concrete decisions at the national levels. As we enter 2010, the key challenge will be to position at the right time for what promises to be a marked bear flattening, as central banks will have a lot whole of hiking to do once they break the impasse, while long term growth and inflation prospects will remain subdued.

The rapid rise in bond yields of the last few months has generated an intense and at times confusing debate on its causes and possible consequences: some see it as confirmation that loose monetary policy is laying the ground for a burst of inflation, some worry instead that it might nip the fragile recovery in the bud. Views on how the Fed and the ECB are likely to react are equally polarized. In this note I briefly summarize our view, which is discussed in greater detail in some of the publications we issued this week.

First: while the surge in long-term bond yields has been driven largely by a rise in inflation expectations, both signal a reassuring normalization rather than fears of runaway inflation. US inflation expectations as measured by break-even (BE) rates have climbed to 200bp, but starting from expectations of zero inflation or deflation at the start of the year. An inflation rate of 2% means price stability, not rampant inflation. In fact, inflation expectations are now back to the average of the last five years (based on 5Y 5Y forwards BE) or still a bit below (based on 10Y BE, see the note by my colleague Harm Bandholz in today’s Friday Notes). This to me is fully consistent with the signs of stabilization in the real economy, with the alleviation of stress in financial markets which has brought most indicators down to pre-Lehman levels, and with the attendant pick up in risk appetite.

Second, in line with this, I do not see the rise in bond yields as a significant threat to the recovery at this stage. At current levels of below 4.0% (about 3.80% at the time of writing), 10Y UST yields are low by historical standards and broadly in line with levels prevailing last year, when the worst of the recession still lay ahead. While a sustained further rise would put undesired upward pressure on mortgage costs, current levels do not see to pose a serious threat to the much-needed stabilization of the housing market.

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Published on  Fri, Jun 12 2009, 15:46 GMT