Monday, 16 January 2012

A Bond Market Boom

In simple terms, there are two key drivers of 10 year government bond yields - risk and inflation.  Right now, I think all sensible people would suggest risk is very elevated which is a key factor biasing yields higher.  In countries where there is no dispute about what is elevated risk (Greece, Italy, Portugal, Spain to name a few), yields are stunningly high.  This seems sensible.

In many other countries, 10 year bond yields are stunningly low.  The 10 year government bond yield is currently around 1.85% in the US, 0.80% in Switzerland, 0.95% in Japan, 1.95% in the UK and 1.75% in Germany.  With the notable exception of Switzerland, these other countries are hardly rolled gold examples of fiscal rectitude and low risk.

So why are yields so low in these countries?

In terms of inflation, there has been a small pick through 2011 although the hugely problematic outlook for the global economy suggests inflation won't go much higher.

Indeed, part of the story could be that the market is pricing in a deflation funk in the year ahead.  If inflation was to fall sharply, these low yields could well be justified and not painted as some form of bubble.

But there is another factor - the massive central bank intervention in the guise of quantitative easing, printing cash, whatever you wish to call it has been targeting the bond market and working to push yields lower.  This unconventional monetary policy action is in place because most central banks can't cut interest rates any more (anyone fancy a -2% cash rate?).   Central banks are working to push bond yields lower in the hope of pushing borrowing rates lower for businesses and households.  This of course is because they are as they try to engineer some form of economic recovery and help the otherwise insolvent banks.

Fair enough too.  It's all hands on deck to try to minimise the misery that a rolling recession brings in the form of high unemployment and wealth destruction.

For now, it seems likely that bond yields will stay stunning low.  There needs to be many months (maybe even a couple of years?) where growth is unquestionably robust before yields click higher even though with each massive budget deficit, the risk level rises. 

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