The big story last week
The big market news last week was about the extraordinary volatility of long term interest rates in the US. The yield on the 10 year Treasury bond began the week at 3.4% then reached 3.8% on the Wednesday only to fall back again to 3.4% by the week end. Their current yield is 3.55%. The similarly dated inflation protected bonds moved broadly in the same direction though as may be seen the compensation for inflation risk assumed by the investor in vanilla bonds increased by 10bps to 1.9% in mid week to then fall back again and also end the week largely unchanged.
US 10 year Treasury Bond Yields – Inflation linked (LHS) and Nominal (RHS)
Source: Bloomberg and Investec Securities
Inflation compensation in the US government bond market – May 2009
Source: Bloomberg and Investec Securities
What happened to nominal and real yields these past twelve turbulent months
In the figures below we show these trends over the past turbulent year. As may be seen the gap between ordinary bond and inflation linked bond yields in the US closed almost completely at year end. Thereafter the inflation protected (TIPS) yields fell away while that of the ordinary bonds rose from their lows of 2%. Thus inflation compensation of 2.5% pa provided by nominal bond yields shrunk to about zero at year end from which they have recovered to their current levels that are still below 2%.
Explaining real and nominal yields
Ordinarily these real bond yields reveal the real state of the global capital markets. When the global economy is expected to grow strongly the extra demands for real plant and equipment and the capital to finance growth in the real capital stock pushes up real benchmark yields (these are well represented in the global capital market by the yield on US TIPS). When the economy is expected to slow down, demand for capital falls away and real yields decline again. Thus these real yields ordinarily are a very good indicator of the expected state of the global economy.
The increase in real yields that occurred at the height of the credit crisis surely requires a different explanation. It suggests that only the safest haven, vanilla bonds, issued by the US government escaped the liquidity pressures of that time. It may be seen below that nominal Treasury bond yields fell away while initially the TIPS yields rose again. That these yields came together again by year end suggests that fears of deflation rather than inflation came to dominate market sentiment.
US T bond yields May 2008- May 2009
Source: Bloomberg and Investec Securities
US bond market; inflation compensation 2008-2009
Source: Bloomberg and Investec Securities
Interpreting the bond market in normal times
Thus we may summarise the evidence provided by bond markets in normal times. The real yields provided by the inflation protected securities (TIPS) tell us about the state of the economy. The higher these yields the more promising is the global economic outlook. Thus the modest increase in real yields recorded recently does help confirm an improvement from the depressed state of the global economy.
The yields on vanilla bonds have to offer compensation for the inflation expected by bond holders. Any increase in inflation detracts from the purchasing power of the interest income bond investors depend upon. Therefore they seek protection from such losses in the form of higher yields. The difference between the higher yields on ordinary bonds and the lower yields on inflation protected bonds issued by the US government tells us just how much inflation protection or compensation the holder of vanilla bonds is receiving.
Winners and losers from unexpected inflation and growth
If inflation expected over the long term tenure of the bonds rises unexpectedly the holders of ordinary bonds lose out while the holders of the inflation protected bonds will gain. Vice versa when long term inflation turns out to have been overestimated by bond investors, and ordinary bond yields decline with real yields on the TIPS unlikely to be much affected by the inflation outlook alone.
These real yields will be affected however if more or less inflation expected is combined with changing expectations of for real economic growth. If more inflation is expected to slow the economy down, that is fears of stagnation with inflation (stagflation) become pronounced, ordinary bond yields will go up and real bond yields will retreat.
The holders of vanilla bonds will lose as the search for protection against more inflation forces nominal bond yields higher and the prices of bonds lower. The holders of TIPS will at the same time benefit from downward pressure on real bond yields and upward pressure on the market value of the TIPS, as the stagnating economy is expected to reduce the demand for capital and so the returns to be expected from all classes of financial securities, including equities. Vice versa less inflation should be associated with faster growth as economic theory suggests.
Thus holders of vanilla bonds fear inflation eroding their incomes. Holders of inflation linked bonds are completely protected against the risks of more or less inflation. However the costs of this protection will depend on the ever changing outlook for real growth and inflation. A combination of faster economic growth with very low inflation will drive real yields higher and so the value of the long dated TIPS lower.
With large government deficits the outlook for inflation and growth remains unusually uncertain – expect volatility
The outlook for global inflation is particularly uncertain at present – hence the extreme volatility of long dated government bond yields. The US government is planning to spend far more than the tax revenues it expects to collect – at the rate equivalent to 12%-13% of GDP over the next two years. This means a great deal more government borrowing and the government debt to GDP ratio is expected to double from its current ratio of 40% of GDP over the next ten years. This means an ever increasing share of US government spending will have to go to paying interest rather than providing for much more popular other forms of government spending.
Getting back to comfort levels is going to take a long time
Getting this debt to GDP ratio back to more comfortable levels any time soon is very unlikely. It will take a combination of a smaller government relative to the economy and higher government revenues. Given the weak expected state of the economy, cutting government spending will seem a particularly unpopular direction to take. Current spending increases inevitably become permanent entitlements. Furthermore, given the weakness of the economy any higher tax revenue to be raised would have to come from higher tax rates rather than a more buoyant economy. And higher tax rates in turn threaten the growth outlook. Thus the pressures on the US government to print money to fund its spending rather than face up to tough choices will mount.
The Fed will be called upon to act with determination and excellent judgment
It is the task of the independent US central bank, the Fed, to very actively resist monetising the debt. There is every good reason to expect the Fed to resist with all the powers at its disposal. However the Fed has already been printing money on a vast scale, not to fund the government but to help the credit and money markets overcome their liquidity fears. Overcoming these fears and the preference of the banks to hoard rather than lend the cash made available to them is essential if the economy is to recover.
The Fed therefore has unusually difficult seas to navigate successfully over the next few years. It must be able to resist monetising government borrowing that will be growing rapidly and borrowing that in time will come to crowd out private borrowers and capital formation by the private sector – diminishing growth prospects. It must also be able to withdraw cash form circulation as the propensity of households and firms to spend more gains momentum. Getting the timing right here so as not to nip any incipient recovery in the bud, while remaining steadfast in the face of higher levels of government spending and higher long term nominal interest rates, will not be easy for the Fed.
Expect volatility in government bond markets and for inflation linkers to be attractive
For all these reasons US and global inflation expected over the next ten years will prove very difficult to forecast with any degree of accuracy. Accordingly nominal government bond yields are likely to remain volatile, while the outlook for real growth remains subject to above normal degrees of uncertainty. If so inflation linkers issued by governments provide an unusual degree of comfort for potentially troubled and inflationary times.