[Mb-civic] The bond markets speak Economist

Michael Butler michael at michaelbutler.com
Wed Sep 22 15:53:35 PDT 2004



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

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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 Haydn¹s 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 world¹s 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.
America¹s 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 Fed¹s 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 doesn¹t 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 Buttonwood¹s 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.

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