What are bond markets trying to say?

The Jakarta Post ,  Jakarta   |  Fri, 10/06/2006 9:58 AM  |  Opinion

Paul Donovan, London

September saw the yields on government bonds in the G7 economies decline across the board. Even the Japanese government bond market, long regarded as a candidate for rising yields, managed to put in an impressive 0.25 percent drop in long term interest rates over the last couple of months -- when yield levels hover around 1.7 percent that marks a significant move. The U.S. bond market has seen some of the largest moves in yield, with a shift of over 0.60 percent from the June high in 10 year interest rates.

Alongside this move in bond markets, equity markets have shown further strength. September saw the Dow Jones index in the United States approach its all time high (set back in 2000). Is it the case that bonds are telling us one thing, and equities another?

The bond market moves do, at least to some extent, reflect a belief in a global economic slowdown and lower (or stable) interest rates in 2007. Expectations for U.S. interest rates at end 2007, for instance, have fallen by 0.85 percent from late June (using 3 month futures contracts). That effectively means that the market is prepared for three quarter point interest rate reductions by the U.S. Federal Reserve.

In Japan, weaker economic data has led investors to rethink their ideas about the speed with which the Bank of Japan will raise rates. Even Europe, which has seen hawkish language from members of the ECB, has had futures markets reduce expectations for 2007 interest rates.

However, bond market moves are more than interest rate expectations. Market attention has also focused on the role of central banks as investors. As in the past, there has been speculation that central banks have been active buyers in the U.S. bond market, contributing to the decline in yields.

Of course, central banks may have decided (like other investors) that the U.S. and global interest rate cycle is near its peak, and invested accordingly. However, ongoing intervention in the foreign exchange markets has increased their ""firepower"" in terms of potential purchases of government securities. This means that, as investors, they are likely to exaggerate other moves in the bond markets.

The bond market moves, therefore, are consistent with the idea of an economic slowdown. The moves are consistent with the idea that interest rates are at or near their peaks in the OECD economies. Are bond markets telling us more than that, and indicating a recession?

A traditional measure of potential recession has been the shape of the yield curve. If the curve inverts (long term interest rates like the 10 year bond yield are lower than short term interest rates), investors have noted that a recession has often followed.

Comparing the U.S. Fed funds rate with 10 year yields today, the yield curve is inverted. Japan's curve is positively sloped (policy interest rates have not moved very far there, of course), but the European yield curve could invert if market expectations for ECB interest rates are realized without any further increase in long term rates.

Today's bond markets are, however, very different from the bond markets of previous decades. An inversion of the yield curve does not automatically predict a recession -- and though there are clear risks to the global growth outlook today, we should not over-interpret what bond markets are telling us.

In the 1970s and 1980s bond yields were primarily driven by inflation expectations, and inflation expectations were closely correlated with economic growth. If investors expected growth to turn down, they would also expect lower inflation, and thus bond yields would fall creating an inverted yield curve.

Today bond yields are less dependent on inflation expectations -- in an era of low inflation the real yield is at least as important as the expectation of future inflation in determining long term interest rates. Moreover, central banks have been generally successful in controlling inflation expectations, and the reaction of inflation expectations to economic growth is far more subdued. This means that movements in the shape of the yield curve, for G7 bond markets at least, are less and less likely to be related to the future path of the domestic economy.

These structural changes suggest that recent moves in bond markets are consistent with investors preparing for an economic slowdown. Changes in short term interest rate expectations are changing long term interest rates as well.

However, bond markets do not seem to be signaling an economic recession -- and investors should remain calm in the face of inverted G7 yield curves. This signals a ""soft"" economic landing, and the positive moves in equity markets which have coincided with the bond market rally do not look so incongruous.

For an economy like Indonesia, this is a case of both good and bad news coming together. The bad news is obviously that there is a slowdown in global growth, which will feed into the Indonesian economy. The good news is that the financial markets are not pricing in the more destructive scenario of an outright recession.

Moreover, although there is perhaps a degree of risk aversion in some investors' attitudes, there is no sudden flight to quality. The higher yielding bond markets of the world, including Indonesia's bond market, are subject to fewer pressures as long as this situation prevails. Indeed, as Indonesia's own interest rates come down, the domestic financial environment becomes a mitigating factor offsetting the international environment.

The writer is Deputy Head of Global Economics, UBS Investment Bank. He can be reached at paul.donovan@ubs.com.

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