U.S. long-term bond yields have leapt by half a percentage point in the past six weeks. Does this solve Mr. Greenspan’s conundrum? Or did the revaluation of the Chinese yuan allow China to cease buying U.S. Treasury bonds, and force yields up?
Neither. Considering that the U.S. Federal Reserve has now raised its benchmark interest rate by 250 basis points, to 3.50%, long bond yields are still very low. The economy is firing on all cylinders, and the Fed is leaning against the wind to prevent overheating — exactly the situation in which bond yields usually rise, thereby helping the central bank to slow the economy.
As for the Chinese yuan yawn, the one-step revaluation has done nothing to stem the tide of inbound capital, whether related to real investments or speculative plays. Furthermore, long bond yields have risen almost everywhere, not just in the U.S. Unless China is also buying bonds from the Eurozone, the U.K., Canada, Japan and Australia, there must be more to the story.
Admittedly, bond yields in the other major economies have risen by only about half as much as U.S. yields. There has been a decided shift in sentiment during July and early August that the U.S. economy is no longer in pause mode, but is back on fast-forward. Bond yields always react to the ebb and flow of economic data, even when the longer-term outlook for inflation remains unchanged. And when the pick-up in economic strength is focused in one country rather than synchronized, that uptick in yields is likely to be greatest in — but not exclusive to — that country.
But this uptick in yields is unlikely to develop into a new trend. The marketplace is prone to exaggerating each ebb and flow in the economic data. Having overplayed the pause in the U.S. economy during the spring, pushing yields below 4%, the market is now overplaying the shift to stronger growth. Fact is, the economy has slowed compared to last year, and inflation is benign.
This leaves Mr. Greenspan with his conundrum. Markets are coming to realise that the Fed’s inflation victory has had two impacts on bond yields, not just one. The conventional view is that interest rates consist of two components — expected inflation, and a real, inflation-adjusted yield. But there is also a third element, which is a risk premium capturing the risk of an outbreak of inflation. The conventional view of bond yields has this premium buried in the real rate of interest.
Expected inflation is lower than ever, that much is clear. But the inflationary risk premium is also shrinking, as underscored by the Fed’s willingness to raise interest rates even when inflation is low and stable, to prevent an inflationary outbreak. This decline in the risk premium appears in the form of a lower real rate of interest, which could boost borrowing levels permanently.
The bottom line? Don’t expect bond yields to rise far or for long. The autumn is likely to bring more signs of moderate, sustained growth, and a diminishing need for monetary tightening.
August 11, 2005
The views expressed here are those of the author, and not necessarily of Export Development Canada.