Has the trend in fall­ing bond yields changed?

Kuwait Times - - BUSINESS - By Hay­der Taw­fik

The bor­row­ing costs for most gov­ern­ments have been climb­ing up over the past few months. Gov­ern­ments that have weak credit qual­ity have seen their bor­row­ing costs rais­ing sharply since the mid­dle of the year, af­ter sev­eral years of con­tin­u­ous de­cline. What sig­nal the de­cline of gov­ern­ment bond prices are send­ing to in­vestors and what is the im­pact on the fi­nan­cial mar­kets?

Yields on bench­mark gov­ern­ments bonds have been fall­ing over the past years, with Ger­man, Ja­panese, Swiss bor­row­ing costs dip­ping be­low zero for the first time just be­fore the mid­dle of this year. How­ever, since the sec­ond half of this year, most yields have risen sharply in some places by more than 50 ba­sis points. This is not a mas­sive sell off but com­ing from neg­a­tive yields can be very painful for bond in­vestors. The up­ward move­ments in gov­ern­ment bond yields might be small but it is telling us that a trend in ris­ing bond yields is on the way. This could be a trend re­ver­sal. Look­ing at the global po­lit­i­cal and eco­nomic back ground one would have thought that gov­ern­ment bond yields should be go­ing down not up. It is now get­ting much harder to fore­cast the trend in in­ter­est rates. So, why the sud­den sell off in bench­mark gov­ern­ment bonds? Could it be the close call on the up­com­ing US elec­tion. But this should not af­fect bond yields that much as the Fed­eral Re­serve sup­posed to be in charge of the di­rec­tion of in­ter­est rates.

Could US vot­ers learned some­thing from the Bri­tish about how to vote for some­thing which can be very vi­tal i.e. Brexit or US pres­i­den­tial elec­tion. There might be a case of US vot­ers not show­ing their true in­ten­tion when it comes to vot­ing for the next US pres­i­dent. This ar­gu­ment might sug­gest that Don­ald Trump could be­come the next US pres­i­dent. This nat­u­rally could up­set the fi­nan­cial mar­kets. I be­lieve pru­dent in­vestors are cash­ing their chips and wait­ing on the side­lines for the time be­ing.

Trump’s un­con­ven­tional ap­proach to sound pol­icy mak­ing is un­likely to be good news for in­vestors and the fi­nan­cial mar­kets. Most econ­o­mists are ques­tion­ing his poli­cies and won­der­ing how and what he will do if he wins the elec­tion. He seems very sus­pi­cious of the way the Fed­eral Re­serve has been man­ag­ing its in­ter­est rates poli­cies. He thinks there is a con­spir­acy against him. This is not good com­ing from a po­ten­tial new US pres­i­dent. He needs to change his words and try to as­sure the global fi­nan­cial mar­kets of sound eco­nomic poli­cies.

As a re­sult, the rise in the 10-year Trea­sury yield to about 1.8 per­cent from as low as 1.36 per­cent at the start of July could be ev­i­dence that fund man­agers are de­mand­ing higher com­pen­sa­tion as a bul­wark against a Trump vic­tory. The re­cent de­cline in global stock mar­kets re­in­forces the pos­si­bil­ity that the smart money is mov­ing to the side­lines un­til the elec­tion is de­cided. The prospect of higher in­fla­tion, which erodes fu­ture bond in­come, typ­i­cally drives yields higher. And con­sumer prices are fi­nally show­ing signs of life af­ter com­ing from very low base or in some cases neg­a­tive in­fla­tion.

Af­ter fall­ing for such a long time, in­fla­tion has started to rise again and this is caus­ing some panic among bond in­vestors. But the con­sen­sus among econ­o­mists is for U.S. in­fla­tion to sur­pass the Fed’s tar­get in ev­ery quar­ter of next year. The U.K. is likely to show av­er­age con­sumer price in­creases of 2.3 per­cent next year, and even euro zone in­fla­tion is ex­pected to av­er­age 1.3 per­cent in 2017, com­pared with just 0.2 per­cent for this year.

It is pos­si­ble that bonds are sim­ply re­spond­ing to a change in eco­nomic fun­da­men­tals by dis­count­ing an ac­cel­er­a­tion in in­fla­tion in the quar­ters ahead. May be the record low and neg­a­tive gov­ern­ment bonds yields were just anom­aly can now yields are ris­ing back to where they should be in times of ris­ing in­fla­tion. May be the Euro­pean Cen­tral bank is not con­vinced of fu­ture in­fla­tion threat and that is why it is still do­ing its monthly pur­chases of roughly 80 bil­lion euro of bonds. The Euro­pean Cen­tral Bank is still in the mar­ket, with pur­chases of 80 bil­lion eu­ros ($90 bil­lion) of bonds each month.

The Fed­eral Re­serve, mean­time, ap­pears poised for its sec­ond in­ter­est-rate in­crease in more than a decade. Prices in the fu­tures mar­ket point to a chance of about 70 per­cent chance of a hike on the De­cem­ber an­niver­sary of last year’s in­crease. No won­der the uni­verse of bonds that yield less than zero is start­ing to shrink.

Bond in­vestors are fac­ing the po­ten­tial of fur­ther sell off in gov­ern­ment bonds. The po­ten­tial re­ver­sal of Quan­ti­ta­tive Eas­ing poli­cies could have a dire im­pact on the bond mar­kets. Bond mar­kets are in­di­cat­ing that there is a change in in­vestors’ per­cep­tion and re­al­ity to­wards gov­ern­ment bonds. Bond and eq­uity in­vestors should be aware of the im­pli­ca­tions of ris­ing bond yields and their im­pact on all sorts of in­vest­ments. @Rasameel

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