The author is president of Queens’ College, Cambridge and adviser to Allianz and Gramercy
The combination of extremely low and relatively stable yields in US government bonds has confused many market viewers for some time, which has also challenged traditional economic analyzes.
This has made the rise in yields particularly noticeable over the past few weeks, which has raised interesting questions about markets, policies and thus the global economy.
This is usually to characterize US yields on government bonds as the most important market indicator in the world. Traditionally, this indicates expectations about growth and inflation in the most powerful economy in the world. It was the basis for prices in many other markets around the world.
With a long history, these benchmarks have disconnected economic developments and prospects over the past few years. Their long-standing correlations with other financial assets, including equities, have broken.
And its information content has become distorted and less valuable. As a result of the global financial crisis of 2008, this is attributed to excessive global savings exerting constant downward pressure on returns.
Over time, however, it became clear that the main driver was the generous and predictable purchase of government bonds by the most powerful central banks in the world under quantitative easing programs, particularly the US Federal Reserve and the European Central Bank.
One should never underestimate the power of central banks intervening in market prices.
The trillion-dollar bonds bought by the Fed and the ECB distorted the ordinary two-sided markets and greatly encouraged many to buy a whole range of assets, far above what they would normally do on the basis of the basics.
After all, what is more assured that a central bank with a fully functioning printing press wants to buy assets at non-commercial levels? Such purchases legitimize previous investments in the private sector and give the assurance that there will be ready buyers of assets for those who want to sell them to relocate portfolios.
It is a setup that encourages private sector purchases by central banks at prices that would traditionally be considered unattractive. No wonder even those convinced of a fundamental misprice were reluctant to be on the other side of a bond market dominated by central banks.
Although these factors remain in play, yields have risen slowly but consistently over the past two weeks from 1.30 percent for the 10-year effect to 1.50 percent.
As global growth prospects weaken somewhat due to the Covid-19 Delta variant, the drivers were a mix of rising inflationary pressures and multiplication signs that central banks will struggle to maintain the era of ‘QE infinity’ – that is, endlessly ultra loose financial conditions. The signs in recent days have included statements of the Bank of England and higher rates in Norway, contributing to movements in some developing countries.
The more volatility the interest rate increases, the greater the risk that returns will suddenly go up, as we start with a combination of very low returns and extremely one-sided market positioning. The larger the gap, the greater the threat to market functioning and financial stability, and the greater the risk of stagflation – the combination of rising inflation and low economic growth.
Like a ball plunging deep into water, a combination of market accidents and policy errors can lead to an increase in returns that will be difficult for many.
Importantly, this does not mean that central banks, and especially the Fed, should slow down what should have already begun – that is, start with the decline in the same level of monthly asset purchases ($ 120 billion) as at the peak of the Covid-19 emergency 18 months ago.
On the contrary, the longer the Fed waits, the more markets will question its understanding of persistent inflationary pressures, and the greater the risk that disorderly market adjustments will undermine a recovery that must be strong, inclusive and sustainable.
Investors, for their part, must acknowledge that the enormous beneficial impact on asset prices of the central bank’s prolonged yield suppression has a consequent possibility of collateral damage and unintended consequences. Indeed, they only need to look at how difficult it has become to find the kind of reliable diversifiers that can support the old portfolio mix of return potential and risk reduction.