SQUARING THE TRIANGLE / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

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Squaring the triangle

The rise in bond yields does not solve a long-running dilemma

Dec 16th 2010 | from PRINT EDITION

THROUGHOUT 2010 financial markets have reflected a strange confluence of views. Government-bond yields have been low (outside peripheral Europe), indicating that investors are expecting low inflation and slow economic growth. But gold, an inflation hedge, has risen steadily, while American equities, a play on growth, have performed well.


This threefold combination cannot last for ever. That it has persisted for so long is probably down to the Federal Reserve’s quantitative easing (QE), which gave comfort to bulls in all three asset classes. The gold bugs saw QE as inflationary, equity enthusiasts saw the tactic as boosting growth and the bond markets had the comfort that the Fed would be the “buyer of last resort” for Treasuries.


Oddly enough, it was the launch of the Fed’s second round of QE in November that seems to have broken the logjam. The ten-year Treasury bond yield has increased from 2.56% to 3.53% since then, with an extra spurt after the announcement of an agreement to extend America’s Bush-era tax cuts, supplemented by a cut in the payroll tax.


The driving force behind these rising yields is a matter of debate. Higher bond yields can result from stronger economic-growth expectations, fiscal worries or higher inflation. Economists at Goldman Sachs attribute the move to the first of these factors. They have marked up their forecasts for the American economy next year by between a half and a full percentage point. A rise in bond yields is part of a return to more normal market conditions and is nothing to worry about.


Paul Mortimer-Lee, a strategist at BNP Paribas, is in the second camp. In a coruscating note entitled “The night they killed Santa”, he fretted that any pretence of fiscal probity had been discarded. “Now it looks like the nice man with the white beard was just there to fund a fiscal expansion. [Ben] Bernanke volunteered to buy more Treasuries and [Barack] Obama decided to help him out by supplying a lot more of them.” But Mr Mortimer-Lee’s fears are not widely shared, at least judged by spreads on American government debt in the credit-default-swaps market.


As for inflation expectations, there has not been a dramatic move higher in recent weeks but there has been a drift upwards since it became clear, back in August, that a second round of QE was in the works. The markets are now expecting American inflation of around 2% over the next ten years. If expectations can be kept at that rate, the Fed would be delighted.


Indeed, even though bond yields have risen, the Fed probably regards the latest round of QE as a success. As well as heading off deflationary fears the programme has given a further lift to share prices. The wealth effect created by the rally will play its part in reviving the economy. But this looks like a revival of the old Fed tactic (much in evidence in the 1980s and 1990s) of underwriting the stockmarket. “The Bernanke put is very much alive and well,” notes David Zervos of Jefferies, an investment bank, who says the Fed is determined to reflate the economy. Yet in the long run creating money to prop up asset prices is not a sustainable tactic.


Higher bond yields have other consequences that might not be quite so welcome.


Mortgage rates in America have risen, casting a further pall over the subdued housing market. Influenced by the Treasury market, yields in Britain and Germany have risen by a third to a half of a percentage point over the past month, even though both countries are making strenuous efforts to keep their budget deficits under control. Higher yields in Germany, which sets the benchmark for other euro-zone countries, put pressure on peripheral borrowers.


Stockmarket investors should also think carefully before they celebrate too wildly over rising bond yields. After all, bulls were previously arguing that low yields were good news for equities, as they encouraged investors to move out of fixed-income assets in search of higher returns. On the best long-term measure, the cyclically adjusted price-earnings ratio, Wall Street looks overvalued on a multiple of 21.9, some 33% above the historic average. That already seems to price in a significant rebound in corporate profits.


The fundamental problem remains. In a “normal” American economy, with 2% inflation and 3% real GDP growth, government-bond yields ought to be around 5%.


But yields at that level would be too high for the health of the housing market, the stockmarket and for other governments worldwide. The markets are no closer to resolving that dilemma than they were at the start of 2010.