Not so risk-free

Rising bond yields could spell trouble for the economy and the markets

GOVERNMENT bond markets are supposed to be the accountants of the financial world: calm, steady and rational. They are not supposed to frighten the horses. But in the days following June 7th, bond investors had a traumatic experience. The yield on the ten-year Treasury bond rose from 4.96% that day to reach 5.33% during trading on June 13th before closing just below 5.2%.

What makes the slump in bond prices all the odder is that Treasury bonds are normally regarded as the risk-free asset, the one that investors buy when they are really worried. What could have prompted the sell-off?

One thing that could cause investors to flee government bonds would be an unexpected rise in inflation. Higher inflation devastates the value of fixed-income assets, as investors found to their cost in the 1970s. But this does not look like an inflation scare. Real yields have caused the vast bulk of the move; inflation expectations have moved up by only around a tenth of a percentage point. And gold, the classic inflation hedge, has fallen in price.

Investors may well have decided that American growth will be stronger than they had previously expected. But, in the absence of inflation, faster growth need not be bad for government bonds; higher tax revenues will make it easier for the government to service the debt. Alternatively, unexpectedly strong growth ought to be good news for equities, yet the stockmarket has also fluctuated wildly.

Another potential explanation is that the markets have given up on rate cuts from the Federal Reserve this year. But the futures market suggests this hope has been dwindling for some time. Global monetary policy is generally being tightened (see article). However, this should not necessarily be bad news for long-dated bonds, if investors believe (as they seem to) that central banks will be successful in containing inflation.

This suggests that economic fundamentals may not be the primary cause for the sell-off. Big market moves like this tend to occur when investors shift their positions in a hurry. In this case, it looks as if some bond bulls decided to throw in the towel. Figures from the Commodity Futures Trading Commission, the Chicago regulator, suggest that, before the sell-off, speculators were betting heavily on lower yields. One of the most prominent bond bulls, Bill Gross of Pimco, an investment-management firm, has just publicly changed his mind.

The hedging policies of mortgage issuers may also have played a part. Because most Americans have fixed-rate mortgages, issuers find they tend to get repaid early when bond yields fall; they hedge this risk by buying Treasury bonds. When rates rise, borrowers are far less likely to repay; that causes mortgage issuers to sell their bonds. The effect can be to exacerbate short-term moves in bond prices.

The big question, however, is whether Asian central banks have lost their appetite for American Treasuries. Part of the reason for the rise in yields was a disappointing auction of ten-year bonds, with foreign investors buying just 11% of the issue. Asian central banks had been buying Treasury bonds with their foreign-exchange reserves in an attempt to prevent their currencies from appreciating too rapidly against the dollar. Some analysts have estimated that these purchases had pushed bond yields between a half and a full percentage point below the level they would otherwise have reached.

The result was that yield curves were “inverted”—long yields were below short-term rates. When he was Fed chairman, Alan Greenspan described this state of affairs as a “conundrum”: such curves had traditionally been a harbinger of recession, but perhaps Asian central bank policies meant this signal was no longer valid.

Asian central banks may now be turning their attention to other assets. The establishment of China's sovereign-wealth fund and its purchase of a stake in Blackstone, a private-equity group, indicate that the Beijing regime may be looking for more exciting returns. Still, if this move is all about the Asian central banks shifting their reserves away from American bonds, it is odd that it has been accompanied by a rise in the dollar against the euro and the yen. True, Blackstone's shares will be denominated in dollars, but it is hard to see a change in reserve policy that would increase the appetite for dollar assets.

Whoever has been selling Treasury bonds, the result is that the conundrum has disappeared; yield curves are now sloping upwards. Sometimes a steepening of the curve can be benign, when central banks cut rates to try to stimulate the economy. But Richard McGuire of RBC Capital Markets points out that this is a “bear-market steepening”, caused by bond yields rising faster than short rates.

A higher risk-free rate will eventually raise the financing costs for everyone, from American homeowners fixing their mortgages, through hedge funds using leverage, to private-equity groups planning bids for quoted companies. It should also bear down (eventually) on economic growth.

This means that, provided that inflation is not getting out of control, higher bond yields will eventually sow the seeds of their own destruction. Slower growth and a loss of appetite for riskier assets will make government bonds look more attractive once more. But with analysts talking about yields breaking out of a 17-year downtrend (see chart), that might not happen for a while.
Jun 14th 2007 From The Economist