What government bond yields are saying about the economy
Sep 11, 2009
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Here's a question perplexing investors, says Richard Cookson of HSBC in the Financial Times. Why are government bond yields falling, even as equity markets are climbing? By rights they should move in the same direction. As signs of recovery mount, the improved earnings outlook should boost equities. Meanwhile bond prices should fall (and yields rise) as the recovery makes higher inflation and interest rates more likely, making the fixed income available on bonds less appealing.
Yet over the past month both long- and short-term yields have fallen as bond prices have risen. The ten-year yield in the US has edged down from 3.7% to 3.4%. In the UK, it's fallen from 4% to 3.6%. In both countries, two-year bond yields remain close to the record lows of late August. So bonds seem to be telling a different story to stocks. History shows that if bonds and stocks are sending contradictory messages, bonds tend to be right, says James Ferguson of Pali International. But it's not entirely clear what bonds are saying.
There is a benign interpretation of the rise in both bond and equity prices, says Cookson. One worry hanging over the bond market has been a huge jump in supply as governments fund record deficits. But signs of recovery may be allaying this concern – governments won't have to borrow as much if economies recover – thus bolstering the market.
But there are gloomier interpretations. Perhaps central banks' injections of printed money into the financial system – including direct purchases of government bonds in some cases – have led investors to believe there is "more buying power in the markets than can be absorbed by a record new supply of government debt", says Breakingviews.com's Edward Hadas. The longer-term danger of all this new money is new asset price bubbles and a "bout of uncomfortable inflation".
Or the bond market may be signalling that low interest rates will be with us for a long time as the West struggles with deflationary pressure, caused by low demand for credit as firms and households work off debt. The recovery is set to falter, hardly good news for equities either. The bond market "may be hard to read", says Hadas, "but it doesn't look like it is telling a happy story".
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