Bond market signals on global economy

This week’s Fund Strategy included a comment by me on what recent developments in the bond market say about the world economy.

For the non-mathematically inclined any discussion of bonds is about as
welcome as a zit to a teenager. All the discussion of yields, yield curves
and spreads can be brain-achingly confusing. Equities, in contrast, seem
like simple beasts.

But there is no escaping the discussion of fixed interest at present. Global
bond yields have started to rise after years of trending downwards. The bond
markets have suffered a sharp sell-off.

Unfortunately identifying changes in yields is the easy part. Working out
why the reversal has occurred is tricky. The answer has profound
implications for the outlook for financial markets and the world economy.

One possible explanation is that inflationary expectations are rising. There
are certainly warning signs on both sides of the Atlantic. For example, last
week Mervyn King, the governor of the Bank of England, gave a
well-publicised speech warning of inflationary pressures. Meanwhile, it was
reported that consumer prices in America were rising at their fastest rate
for almost two years.

Rising inflation is general painful for bonds but it would signal a rebound
in the global economy. Inflation hurts bonds as it tends to erode their
capital value. But it can also coincide with resurgent economic growth which
benefits the bulk of society.

Judging by the reaction of the stockmarket it seems that many equity
investors may accept the inflation with growth scenario. Stockmarket
investors did not panic in response to the bond sell-off. Although equity
investors are relatively cautious (see the Merrill Lynch survey story on
p10) they seem generally positive.

However, there are alternative possible explanations for rising bond yields.
Perhaps the most plausible is that Asian and Middle Eastern central banks
are reducing their purchases of US treasuries.

According to this theory the massive purchases of American government bonds
by central bankers has artificially depressed bond yields. In other words,
foreign subsidies for American consumption have manifested themselves in a
distorted bond market.

Now, it is argued, the trend has gone into reverse. Central banks are
finally diversifying their holdings away from American government debt.

The problem is that it is hard to be sure what is really happening. Since
central bankers are notoriously secretive about the assets they buy it is
impossible to be certain what they are holding.

It is possible that they are diversifying into sovereign wealth funds which
are buying assets other than American bonds (see May 28 comment). No one
knows for sure.

Developments in the bond markets should be watched closely in the coming
months as they could help discern the current character of the global
economy.