December 19, 2012, 12:56 p.m. ET

Bonds Beware Central Bank Regime Change


Revolutions are usually noisy affairs. But the apparent revolution in global monetary policy appears to be passing off remarkably quietly. From New York to Tokyo to London, a trend away from strict inflation targeting, the orthodox policy of recent decades, seems to be emerging. Yet debt markets have betrayed few signs of concern. Are investors being complacent?


In the U.S., the Federal Reserve has announced that future monetary policy tightening will depend on a hard target for falling unemployment and a softer target for rising inflation expectations. That looks like a tilt toward growth as the priority over inflation. In Japan, the election victory of Shinzo Abe likely heralds a more activist Bank of Japan, potentially with a higher inflation target. And in the U.K., a debate about the Bank of England's mandate is looming after Mark Carney, current Bank of Canada chief and future BOE governor, suggested central banks could consider targeting nominal growth rather than inflation. That suggestion was welcomed swiftly by the U.K. government. All that could mean 2013 becomes a year of unprecedented money printing and policy easing as central bankers strive to boost growth—and inflation, the nemesis of bond investors.

Yet Treasury, gilt, JGB and Bund yields are remarkably well behaved. Yield curves have steepened, but benchmark five- and 10-year yields are mostly within recent ranges and in absolute terms are extremely low, offering little cushion against inflation. The clearest reaction has been in Japan, where 20- and 30-year JGB yields have risen to their highest since April—with 30-year yields close to breaking above 2%—and the yen has fallen to its lowest in over a year against the dollar and euro.

Why are bond markets so calm? First, investors may be more focused on more immediate risks, such as the fiscal cliff in the U.S., and may be hesitant to switch positions before the end of the year. Some may have already effectively shut down for 2012. They also remain unsure about the growth outlook, with doubts about how effective central-bank policy can be at this point.

Second, more monetary-policy accommodation suggests short-dated bond yields will remain pinned close to zero. To achieve their aims, central banks might undertake more bond purchases or pump more liquidity into markets, further underpinning prices. More financial repression—such as regulations requiring some institutions to hold government bonds—may well keep yields low. But that risks simply storing up a more vicious reaction for the future if inflation expectations rise.

Third, inflation doesn't seem like a clear and present danger to many investors, particularly since wage growth in the developed world remains anemic. The danger is that at some point this consensus will shift, and many holders of long-dated debt will head for the door.

The message in the longer run seems clear: Expect long-dated bonds to suffer and currencies to fall in value as central banks compete on stimulus. Revolutions are rarely victimless, after all.

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