Recent bond market moves and the interest rate outlook
The US bond market has been on a consistent downtrend since the start of the year when 10-yr government yields reached a low of around 2%, then nearly doubled to a few basis points short of 4% by mid June. The selloff this year has been much more pronounced than in other countries, in part, due to investors expecting the US economy to come out of its recession ahead of everyone else. This is because the down-leg of the US cycle started way ahead of that in other countries and because the US authorities offered the fastest and deepest policy response to the economic and financial crisis. The degree of monetary and fiscal stimulus has been deemed strong enough and sufficient to bring the economy out of a recession and to, in due course, warrant higher policy rates. Another major reason for the selloff in US bonds has had to do with concerns about excess supply of government paper, as unprecedented fiscal deficits are set to double the amount of outstanding US government debt over the next several years, while foreign holders of US bonds are already nervous about the saturation of Treasuries in their portfolios.
Eurozone bond markets have been slower to fall in value. German Bunds, for instance, reached and traded around their cycle highs from December to the end of March, then fell back, with 10-yr yields rising from around 3% to 3.8%, a much smaller increase than in the US. Other Eurozone bond markets have done better. The smaller-country bonds, which sold off the most during the crisis, have done the best this year. Greek 10-yr bonds, which were one of the worst performing in Europe last year, have for instance, not changed in value, with 10-yr yields at slightly below start of year levels. The large Eurozone bond benchmarks have outperformed the US because Eurozone monetary and fiscal stimulus has been much smaller relative to that in the US, with Europe succumbing to economic weakness with a lag. Rising supply is also not deemed an issue in the Eurozone, where governments have been more frugal with their spending, where by choice, or by lack of funds.
The UK bond market has been more erratic since the start of the year, with Gilts falling in value sharply in January and early February, then rising to new highs, then falling back in line with the selloff in core Eurozone bonds in April, May and early June. 10-yr Gilt yields are now around 75bp above start of year levels at 3.7%, having peaked at just over 4% and are slightly above those in Germany. The significant outperformance of UK bonds relative to those in the US this year stands out somewhat, considering that the degree of UK monetary and fiscal easing has been at least on par with that in the US. One possible explanation for the better performance is that the UK economic cycle is still lagging that in the US by half a year, or longer. Another has perhaps to do with structural issues, as markets worry if the UK economy could return to its former vigour in view of the changed landscape in the financial services industry. The exposure of foreign investors to UK government paper is also not an issue for Gilts.
The decline in core bond markets this year has also had to do with some concern about the possible build up of inflationary pressures, which could materialise in the next several years, due to the ultra-lax monetary policy in all industrial nations at present and the significant fiscal relaxation in the US, UK, China and other major economies. The inflation concern is also creeping up in line with the improvement in economic fundamentals and as commodity prices rise again, with the latter having appreciated on average by over 25% since a low point in February. Such concerns have been reflected in a consistent rise in bond market breakeven inflation expectations this year in all developed economies except Japan. Surveys on consumer inflation expectations have also failed to decline to the degree expected and are in some places showing signs of some increase recently.
Markets are still not particularly concerned about potential inflation as significantly higher unemployment and the cut backs in economic output mean that there is substantial unused capacity in most major economies, which is deflationary. But it is unclear when and how quickly capacity considerations will fade and to what extent will monetary and commodity cost factors counterbalance the slack in final product and labour markets. In this context, central banks are no longer talking about further policy relaxation, but are contemplating the timing and nature of the withdrawal of monetary stimulus currently in place.
The story at the short-term spectrum of the interest rate curve, which is priced to the market’s central bank policy expectations plus a few premia, shows that markets are already gearing up for some non-negligible central bank tightening in 2010. The US curve is pricing in close to two percentage points of rate increases next year, starting early on, possible at the beginning of 2010, or even towards the end of this year, which would take the Fed Funds rate to 2% in the next eighteen months. US central bank rates are then expected to raise by a further percent in 2011 to 3%. The UK market is priced similarly, with the BoE seen rising rates by around two percentage points in 2010 to over 2% depending on how risk premia changes and by around a further one-and-a-half, or two percentage points to 4% in 2011. The ECB is expected to lag the tightening cycle, with rates in the Eurozone seen rising by only a percent in 2010 to 2% and then by a further percent in 2011 to around 3%. The ECB is expected to tighten policy by a smaller amount next year, starting later than other central banks, because it is beginning from a higher base and also as the Eurozone activity and inflation cycle is expected to lag that in the US and the UK.
The prospective policy tightening priced in by markets was even more pronounced earlier in the month, following the publication of much better than expected US jobs data, when markets factored in an additional one percentage point of rate increases by the Fed and the BoE next year and half a percent for the ECB, over the space of a few days. Since then, central banks have been hard at work to reassure markets that policy won’t be tightened soon, which has seen money market rates unwind around half of the post US employment report increase, with current projected policy rates consistent with the those described above. The rise in market interest rates, especially in the past month, shows that investors are edgy and ready to start leading the central banks into tighter policy.
In a cyclical sense, the central bank rate outlook is more uncertain than usual as the downturn in the past two years may have impaired a number of economies structurally, which could imply a lower long-term neutral benchmark interest rate than in previous cycles. On the other hand, central bank policymaking may change away from inflation targeting, which could lead to a much higher neutral interest rate in most developed economies in the next several years.
The sustained decline in consumer inflation in the past two decades prompted central banks to offer unnaturally abundant liquidity in a bid to keep inflation above zero, which fuelled asset market bubbles resulting in the current crisis. The fall back in inflation in the past 15-20 years, despite very lax monetary policy, may have been an exogenous phenomenon, related to the emergence of China and other emerging low-cost producing nations on the global scene, flooding the world with inexpensive products and driving goods inflation lower. Technology shocks, most notably in communication, and the globalisation of labour and product markets may have also suppressed consumer prices for an extended period despite an unnaturally high level of liquidity. This may not last. China’s deflationary influence of yesterday may turn into an inflationary force of tomorrow as commodity prices rise while the BRICS and their neighbours are building infrastructure. Following that, a much wealthier world population will change the supply and demand dynamics and disinflationary shocks will only be tied to eventual bursts of technological advancement. These are considerations that are not immediately pressing, as governments are still too busy saving the day to worry about the longer term. As economies stabilise, the monetary policy regime will become a hotter topic, however, as governments fret about preventing another catastrophic bubble from materialising. At the moment, the focus is on financial regulation, but unless liquidity is curbed at the cost of higher interest rates, a bubble will form somewhere, possibly in commodities, without a doubt.
For the near term, the most probable scenario is that the Fed, BoE and the ECB will start raising interest rates from H2 of next year and through 2011, especially if commodities move higher. But in terms of what expectations are embodied in the market and under the assumption of unchanged policy regimes, UK base rates already seem fairly priced for the next two and a half years and so are those in the Eurozone, while US benchmark rate expectations could move a bit higher. Interest rate markets will price in more tightening in the coming months, however. They may have to price out some of what is in the curve for the next twelve months, but only to factor in even more for the following twelve.
Nikola Mirtchev