HEARD ON THE STREET
March 12, 2012, 1:03 p.m. ET
Explaining the Bond Yield Conundrum
By RICHARD BARLEY
Are safe-haven bond markets on another planet? Risk appetite has come roaring back in 2012 as central banks have provided huge amounts of liquidity, economic data have been better than expected and the euro-zone crisis has receded—with Greece avoiding a disorderly default. But there has been no corresponding selloff in German bunds, U.S. Treasurys and U.K. gilts.
That is surprising given the huge rally in risky assets. The MSCI World equity index is up 9.2%. Global investment-grade corporate-bond spreads have tightened 0.6 percentage point, Barclays Capital indexes show. Italian government bonds have returned 12.8%. Yet 10-year German bund yields fell to 1.76% Monday, a fresh low for the year.
By some measures, core bonds look overvalued. One guide is that long-term risk-free bond yields should be roughly equal to nominal economic growth. But with U.S. nominal growth at 3.9%, 10-year Treasurys at 2% are almost two percentage points overvalued, UBS notes.
On the other hand, with central-bank policy rates at zero and the U.S. and the U.K. having undertaken quantitative easing, long-dated yields look more rational. Interest-rate curves are very steep, meaning there is actually a big risk premium in long-dated yields. The 1.7-percentage-point gap between two-year and 10-year Treasury yields is more than twice the long-run average. And there is good technical support for bunds, Treasurys and gilts, as there are few substitutes for them after other "risk-free" assets turned out to be anything but.
Low bond yields mean one of two things, therefore. One is that investors fear central-bank liquidity is only plastering over the cracks, and they expect a resurgence of the global financial crisis, hurting stocks, corporate bonds and peripheral euro-zone debt. The other is that long-term yields are rational, in which case yields on other risky assets should converge further with them: The risk-on rally can continue without safe havens selling off.
The key to the conundrum is that central-bank rates are at zero and expected to stay there. As long as that is the case, don't bet on a big rise in bond yields.
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