May 19, 2015 6:44 pm
The wary retreat of the bond bulls
Long fall and recent collapses in nominal and real yields on safe securities should be at an end
We should want to see yields rise, but modestly. This is also what we should expect.
In Japan, deflation even became entrenched in the 2000s. From the late-1990s up to the crisis, the main explanation was a decline in long-term real interest rates from a little below 4 per cent to a little above 2 per cent, as shown in yields on the UK’s index-linked gilts.
These are close to zero in the UK and US. In America and Britain people expect prices to keep rising modestly, in line with targets, though not in Japan. The European Central Bank’s recent policy measures are designed to keep inflation expectations up in the eurozone. Meanwhile, the risk premium can only be estimated. Over the long run, it has been volatile. Estimates from the New York Federal Reserve suggest it is now close to zero.
First, nominal and real yields are very low in all the important high-income countries. Thus, they are vastly more likely to rise than fall from recent levels, unless sustained long-term growth and positive inflation are over.
Second, yields are astonishingly low in core European countries. If the ECB succeeds with its endeavours and so the recovery continues to gain pace, then yields should rise a great deal. The same should ultimately be true for Japan.
Third, post-crisis headwinds — among them, high levels of household debt — nevertheless are strong. Also important must be the economic slowdown in China. Thus, the equilibrium global real interest rate is likely to remain low by historical standards for quite a long time.
Fourth, sharp rises in expected short-term interest rates and so in long-term conventional yields are only likely to follow a strong recovery (which would drive up real yields) and so perhaps a strong rise in inflation expectations. This is possible. But it seems unlikely. Whether a big jump in yields would be a good thing depends mostly on whether it is driven by optimism about the real economy or pessimism about inflation.
Finally, falls in nominal and real yields below recent low levels would imply a descent into deflation. Central banks can and will prevent that; never say never, but this looks highly unlikely.