Admittedly, these developments suggest that bond yields will eventually head up, especially with almost all benchmark yields in the US and UK now negative in real terms.
But, with consumers accounting for about two-thirds of GDP, repairing balance sheets and the ‘stag’ part of stagflation yet to play out, it will be some time before central banks can tighten conditions freely without risking economic relapse. The correction, when it comes, could be far more limited than the doomsayers predict. And, rather than a repeat of the 1994 ‘bear leg’ when the US Fed tightened aggressively and without warning, it should be different this time.
Gentler than 1994
Why? While default in the eurozone looks inevitable, the hit to global yields from some of the other developments should be limited by at least three factors.
First, default concerns in the US and UK, whose debt is in local currency and can be met by the printing press, look overdone. The threat to US ratings looks no more at this stage than a shot across the bows of Congress and the administration to agree a deficit stabilisation plan before the 2012 elections. If not, its AAA-rating could be lost.
But they will surely have the sense to at least thrash out a plan, albeit postponing most of the fiscal tightening to 2013, and raise the debt ceiling. Republicans will doubtless remember 1996 when their sponsored government shutdown prompted Moody’s to lower its Aaa to a negative outlook, but had the unintended consequence of helping Clinton’s re-election. In turn, Obama could blame any fiscal fine-tuning on the opposition and the rating agencies!
Ironically, fiscal laxity could even support bonds in the short term if it activates QE3. This could follow if international investors, especially China, worried about a downgrade become reluctant to step in as the Fed stops buying Treasuries after June.
Second, the lagged effect from oil; not only is the spike in real oil prices over four-fifths of its record high in 2008, it heralds, if sustained, even higher US unemployment. This will concern Obama and a Fed needing to see a more than four-million unemployment reduction before worrying about wage inflation. Surveys are already highlighting margin pressures.
Way short of normal
Thirdly, and linked to that, the only slow pace of policy normalisation, unlike 1994. It’s just too soon to risk significantly higher bond yields. We can of course expect some tightening of conditions next year as crisis-level rates end and recoveries clip output gaps and fiscal deficits. But, our ‘policy-looseness’ analysis suggests that, even in 2012, most G5 central banks will do no more than nudge real policy rates from negative to closer to zero , leaving overall policy positions, monetary and fiscal, way short of what’s ‘normal’ by historical standards.
The US should raise rates, but, with a meaningful fiscal tightening deferred, its overall stance will be looser than warranted. Japan will go the other way, allowing a chance to get the yen down. The eurozone will accelerate its tightening, despite the periphery’s misery, as will the UK, though this will be just a small step to correcting a decade of unmatched policy loosening.
So, while logic suggests bond yields should head up, we could end up with something far closer to the relatively gentle rises implied by forwards curves than anything more severe.
