Buttonwood of the Economist:The bond markets speak

The bond markets speak
Sep 21st 2004 From The Economist Global Agenda

Growth is slowing, inflationary dangers are subsiding and interest rates are near their peak. That, at least, is the message from bond markets around the world

IN TRUTH, there should be few duller things in life than investing in government bonds, a matter of clipping the coupons and getting the principal back upon maturity. Only marginally more exciting, in other words, than the M25 on a Friday afternoon or Haydn’s early string quartets. Yet government-bond markets the world over have been strangely fascinating in recent weeks because they have been rising sharply when in times past they would have fallen with a thud. After all, the price of oil is again barrelling upwards and the Federal Reserve—setter, for better or worse, of the world’s risk-free rate of interest—is raising that rate. The benchmark federal funds rate went up again on Tuesday September 21st, to 1.75%, the third increase this year. But the yield on ten-year Treasuries has dropped to a whisker over 4%; on Bunds, their German counterparts, to roughly the same level; and on Japanese Government Bonds to under 1.5%.

To be sure, there are some distorting factors driving Treasury bond prices higher and yields lower. Buying by Asian central banks, and the Bank of Japan (BOJ) in particular, is one of them. In a spree that lasted until March this year, the BOJ comfortably bought more dollars (on behalf of the finance ministry) than anyone else in history, and plonked the proceeds in Treasuries. Though it has now stopped these dollar purchases, it still has plenty of cash in the bank ($122 billion at the end of August) that it wants to invest in higher-yielding Treasuries. In both July and August, it bought $15 billion of Treasuries. Still, given the huge size of the Treasury market, such purchases probably only account for a small fraction of the fall in yields. Whether you agree with it or not, the message from the bond markets is clear: global growth is slowing, inflationary risks are transient and falling, and interest rates are nearing their peak.

The fall in Treasury yields has been as dramatic as it has been unexpected, to most investors at least. Ten-year yields peaked in the middle of June at 4.9%, and have ratcheted down ever since. Indeed, the bear market in bonds for the past year or so has really only consisted of two sharp sell-offs: from the middle of June until early September last year, and from the middle of March this year until the middle of June. Both sell-offs were caused largely by better-than-expected jobs numbers, and if anything look to be as much of an aberration as the employment reports that caused them. Despite the inflationary scare earlier this year, bond prices have actually risen in more weeks over the past year and a half than they have fallen.

That is decidedly odd. For short-term interest rates in America are still strikingly low. Real rates—that is, adjusted for inflation—are, in consequence, still negative. Very negative, in fact. Consumer-price inflation in America is currently about 3%, which makes real interest rates around -1.25%. The number-crunchers at Goldman Sachs have found that since the early 1960s, the real Fed funds rate tended to fall to just below zero at the trough of interest-rate cycles, and then rose to a couple of percentage points above it within a year. This time round, the real Fed funds rate only fell to nothing a year after the trough of the cycle at the end of 2001, and has averaged about -1.5% ever since. Monetary policy, in other words, is still very loose. If the past is a guide, and assuming that inflation remains where it is, the Fed funds rate would need to rise to 3.5-4% to bring real rates back in line.

Yet the futures market thinks that the Fed will put up rates by only another half a percentage point or so, to about 2.25%, and then stop. The reason lies in growth and inflation expectations, both of which have been falling. America’s giddy growth rate certainly seems to be slowing. The economy grew by an annualised 2.8% in the second quarter, having grown by 4.5% in the first. It is unlikely to grow much more in the third quarter.

Alan Greenspan, the Fed’s chairman, thinks this only a temporary lull; and the strong performance of equities and corporate bonds recently suggests that investors are giving him the benefit of the doubt. The key therefore seems to be inflation, which is low and getting lower. In August, core inflation—ie, stripping out energy and food—rose by only 0.1% for the third month in a row. And overall inflation will continue to fall too, or so investors think: the inflation expected in ten-year inflation-indexed Treasuries (so-called TIPs) has fallen by six-tenths of a percentage point since June.

To anyone raised in the 1970s, such expectations are astonishing. Oil is now over $46 a barrel, the real Fed funds rate is still negative, the dollar is weak and looks set to get weaker, the budget deficit is climbing to the stars, yet still markets expect inflation to fall. It seems to defy logic.

Yet logic there is. The high oil price is a tax on America, or indeed on any other country that doesn’t pump more of the stuff than it consumes. But it can be passed on to consumers in higher prices, or lower growth, or both. The market seems to have decided that it is being passed on only in the form of lower growth. It is not the only tax that is coming due: by the end of this year, consumers are to be hit by the withdrawal of tax rebates of a more traditional sort. And if growth and demand are slow enough, and competition from manufacturers elsewhere (particularly in Asia) stiff enough, consumer inflation will fall.

That, it seems, is the big change from the 1970s. And given the level of bond yields the world over, it seems to be a global phenomenon. If this is indeed the case, the more surprising thing to Buttonwood’s eye is not the level of government-bond yields, even though much disinflation is taken on trust, but the level of the stockmarket, which seems to ignore it entirely.