Global Agenda: Befuddled by bond yields

There is little debate about equities in 2014. But the same can hardly be said for bonds.

By PINCHAS LANDAU
Money (photo credit: Wikicommons)
Money
(photo credit: Wikicommons)
Stock markets around the world are ending 2013 at the highs of the year that, in many cases, are alltime record highs. Even most markets not actually at these lofty levels, such as London and Paris, are not far from the highs they recorded earlier in the year. The only important bourse in the world to which the foregoing does not apply is China, where prices are in clearly defined bear markets.
However, since the great majority of Western investors do not have much exposure to China, they don’t pay it much attention. Anyway, who believes Chinese data about anything? They are all assumed to be deliberately distorted, although it’s difficult to understand why the Chinese would deliberately distort their stock-exchange downward. But then what can befuddled occidental minds understand about the devilishly clever Chinese, who famously take a long-term view of things and rarely if ever indulge in speculation, let alone gambling? The mainstream view is that the only open question about equity markets in 2014 is whether they will be as good as they were in 2013 – or perhaps better. Pessimists are people who think that the main share indices will not rise next year by as much as they did this year. Genuine bears are virtually extinct, and many of the biggest have transformed themselves into bulls, with all the fervor of converts to a new cause who have finally seen the light.
There is, therefore, little debate about equities. But the same can hardly be said for bonds. The discussion here is both more heated and more complex, with the central question relating to the direction of yields on medium- and long-term bonds: Will yields continue to rise in 2014, as they did over the course of 2013 (albeit in a sporadic and irregular manner)? If they do, that means that bond prices will fall and investors will suffer another losing year in this market – something that hasn’t happened for a very long time.
On the other hand, if bond prices revert to the longterm uptrend that characterized them for more than 30 years, from 1981 to 2012, what would that mean? Obviously, rising bond prices would be good for bond investors. But they would mean that long-term interest rates were falling again, which would suggest that the economy was weak, or at least weakening. It could even presage outright deflation, in which case the Federal Reserve would almost surely launch another program of bond buying to try and boost economic activity. In short, rising bond prices would reflect trouble for everyone other than bond investors.
What would falling bond prices mean – other than losses to bondholders? In the normal run of events, rising bond prices would suggest that economic activity was rising, so that the demand to borrow money was pushing up the cost of money; i.e., interest rates, which include bond yields. This state of affairs would justify the Fed’s recent decision to start reducing the extent of its bond buying and would encourage it to continue “tapering” over most of 2014 until it has eliminated the program.
However, at this point in the analysis we note a strange phenomenon: Economic theory and recent practice seem to have parted company. Whereas one would expect that a Fed bond-buying program would push bond prices up (and yields down), while its termination would cause prices to fall (and yields to rise), the experience of both QE1 and QE2 was exactly the opposite: When the program was running, prices fell, but when it stopped, they rose.
This can be explained (economists can explain almost anything, ex post facto). But it is still confusing, and confusion upsets investors and the markets. Worse, it makes 2014 very difficult to predict: Will the end of QE3, via the Fed’s tapering, create a situation similar to that after QEs 1 and 2, in which case yields will fall – or not, in which case they will go up? Furthermore, if yields fall, would this not reflect weakness in the economy and thus lead to renewed Fed activism – QE4, presumably? This is plainly possible, given the precedents, but there is a growing consensus that QE is suffering from rapidly diminishing returns, so why do even more? Yet the alternative scenario is worse: If yields rise and the Fed launches more buying, but yields continue to rise (because investors, whether domestic or foreign, continue to sell bonds), then the risk of panic and a sharp downward move in bonds becomes real.
Given the huge debt accrued by the public sector in recent years, the still massive debt burden of the household sector and that many companies and sectors in the economy are kept afloat solely by the ready availability of cheap credit, a prolonged or significant rise in interest rates would wreak havoc. That’s why the key thing to watch as we move into next year is the yield on 5-, 10- and 30-year government bonds, in the US, Japan and the main European economies.
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