- Bond yields are lower than we would expect given the recovery in the economy.
- This is due to the Fed’s promise to keep rates low, which means that if policy changes, bond prices could fall sharply.
Gilts have become less cyclical.
Usually, gilt yields rise during the economic boom as investors sell them in anticipation of higher inflation and interest rates and switch to assets like stocks that would benefit from economic growth. In the past few months, however, this has not happened to the extent that it is otherwise.
This is what my diagram shows. It shows that from 2010 to 2020 there was a strong correlation between five-year returns and the manufacturing purchasing managers’ index (PMI) measured by Markit. A stronger economy meant higher returns and a weaker economy, lower, as one would expect.
However, since last summer this connection has broken down. Gilt returns have not risen as much as you’d expect given the rise in the PMI. To roughly quantify this, if the relationship between returns and the PMI had continued from 2010-19, five-year returns would be around 1.9 percent today. In fact, they are below 0.3 percent.
It’s hard to attribute this decoupling to quantitative easing that is depressing returns. Previous doses of QE in 2010-12 or 2016 – didn’t significantly upset the cyclicality of yields, so why should the last dose have done this? The question is especially tricky because, as Christopher Martin of the University of Bath and Costas Milas of the University of Liverpool have argued, later doses of QE are less effective than earlier ones.
Nor is it easy to attribute this to the long-term global downtrend in returns, caused, among other things, by a combination of (among other things) a lack of safe assets, falling profit rates, a lack of investment opportunities and slower economic growth. Surely there is such a trend. But there were also cyclical ups and downs. The question is why the cyclical increase in yields has been so weak since last summer.
One possibility is that the PMI is overstating the strength of the economy. It measures the proportion of companies with increased activity, which means that the index could be exceptionally high, even if many companies report only slight improvements.
Accordingly, markets see a temporary spike in activity after the lockdown and expect a return to normal, sluggish growth rates soon.
But there is still something going on. The puzzle depicted in my diagram is not limited to the UK. Something similar happened in the USA, where yields have risen only slightly since last summer given a strong economic recovery.
A big reason for this is the Federal Reserve’s forward guidance on interest rates. She has promised to keep the Fed funds rate near zero until she believes the economy has reached “maximum employment” and inflation appears to be above two percent “for some time”. Part of the reason for the decline in yields since April is that markets were surprised the Fed held on to that promise amid rising inflation.
With the proportion of people of working age now lower than at any point between 1983 and 2019 and the Fed believing that the current high inflation is only “temporary”, futures markets interpret this promise to mean that interest rates will not hike until late next year, and rates will stay below one percent through 2026. With five-year yields matching the short-term rate that investors expect through 2026, it will cause US yields to fall. And because developed country government bonds are close substitutes for one another, that means low returns in the UK. The Bank of England’s view that current above-target inflation “will be temporary” and therefore rates here will not rise rapidly keeps gilt yields low.
However, all of this poses a problem for the Federal Reserve: if inflation proves to be more than temporary, how can it reverse forward guidance without triggering a sharp rise in interest rate expectations, and hence bond yields?
There are good reasons to avoid this. Such a sell-off could well be accompanied by falling share prices, as investors fear a possible reversal of the “reach after return”, which has not led investors out of an upward trend, but merely out of desperation over the lack of return on shares in shares. Such a double sell-off would mean a serious tightening of monetary conditions: both higher borrowing costs and mortgage interest rates and a negative impact on wealth from falling stock prices.
To avoid this, the Fed only needs to gradually adjust its guidance – but it is not known whether this can be done without worrying the markets.
In that sense, Fed critics are absolutely right when they argue that the markets have become addicted to cheap money – because pulling out of that solution will be painful when the markets turn cold.