Markets are dumping bonds – the implications could be serious.
The price of a bond and the yield it pays are like mirror images – they are complete opposites. When the price of a bond is high, its yield is low. And in recent years, the price of bonds has been very high indeed. That’s what you get when interest rates are at record lows. That’s what you get when central banks invent a tool called quantitative easing and buy lots of bonds.
It means the cost of government borrowing is low, relative to debt of course.
But there is another, more subtle effect.
When companies are valued by analysts they are supposed to take into account estimated future dividends into perpetuity and discount these dividends by a rate of interest to create a net current value. So, a company’s value depends on two things: estimated future earnings and estimated future interest rates. When rates are low, and are expected to stay low for some time, shares should rise in value.
There is a more obvious effect too, when bonds are expensive, the markets look for alternatives, increasing the allure of equities.
And stock markets have had a good run, breaking records with almost tedious regularity in recent months. Surging stocks have supported business confidence and also helped supports consumer confidence, especially in the US, where indexes tracking consumer confidence have been hovering around a 16-year high.
But this month has seen central bankers change their tune. As was pointed out here yesterday, first off, the Bank of England’s monetary policy committee – MPC – surprised the markets, when three of its eight members voted for a rate hike earlier this month. Then the bank’s chief economist, Andrew Haldane, suggested rates may need to rise soon, and then the governor, Mark Carney also seemed to start siding with those who want higher interest rates.
Interest rates have been on an upward course in the US for a while, but up until a few days ago, the markets were assuming that the UK would not follow suit for some time. This view has now changed. At the same time, we have had a confusing message from the European Central Bank, but it does appear that this bank, too, is coming around to the view that interest rates need to tighten.
But what is interesting about this change of mood, is that it comes at a time when inflation in the US and euro area seems to be falling – after surging earlier in the year, inflation has fallen back sharply over the last two months in both regions.
It is still rising in the UK, of course, but this is down to falls in sterling following the Brexit vote and more recent political uncertainty.
The result: both the euro and pound have risen against the dollar. The yield on government bonds has jumped.
For example, the yield on UK ten-year government bonds has risen from less than one per cent in the middle of June to 1.25 per cent at the time of writing. In the last three days it has increased from 1.03 per cent to 1.25 per cent.
Bond yields are up in the euro area, too.
The point to bear in mind is that, the UK aside, there is no sign of rising inflation pressure, and even in the UK what pressures that there are will probably not last for more than a year or so.
So, it is not just bond yields that are going up, but yields relative to inflation – and that may not be good for equities.