Global *Bond Bubble Bursts - Benign or Malign?<http://www.morganstanley.com/views/gef/index.html#anchor9836c2e0-5107-11de-96f6-3f25a44c9933> * June 04, 2009
By Joachim Fels & Manoj Pradhan <http://www.morganstanley.com/views/gef/team/index.html#anchorjoachimfelsmanojpradhan>| London *Central banks and the bursting bond bubble: *A key issue that central bankers in Europe and the US will have to consider at their upcoming policy meetings (ECB Council, Bank of England's MPC on June 4, FOMC on June 23-24) is the recent sharp sell-off in government bond markets. What's behind it? Is this a sign that quantitative easing (QE) isn't working after all? Could the back-up in yields derail the anticipated recovery in the second half of the year? Should central banks' bond purchases be stepped up in response, or should they be slowed down? Here's our take on the reasons behind the back-up in yields and its likely implications for the economy and central bank policy. *The bond roller-coaster:* To put things in perspective, it is important to note that the recent sell-off in government bonds merely continues a trend that started already at the beginning of the year. Between mid-November and the end of last year, the 10-year US Treasury yield collapsed from a range of 3.5-4% to a low of only 2.05% when it became clear that the global economy was falling off a cliff and deflation fears surged. From the low in late December, yields have now backed up by some 150bp to 3.58%, back to the range that prevailed for most of 2H08. As we see it, there are two main factors behind the rise in yields over the past five months: *Unwinding of previous overvaluation:* To a large extent, we view the rise in bond yields as the unwinding of a bond bubble that inflated late last year. Bond yields have not shot up to unsustainable highs, but have rather bounced off unsustainable lows. To illustrate this point, we illustrate the actual 10-year US Treasury yield along with MS FAYRE, our estimate of the fundamental fair yield. MS FAYRE (the Morgan Stanley FAir Yield Regression Estimate) is based on an estimated long-run relationship between 10-year yields and a small set of ‘fundamentals', including the real fed funds rate, survey-based inflation expectations and inflation volatility (for an exposition of the model, refer to J. Fels, M. Pradhan, *Fairy Tales of the US Bond Market*, July 26, 2006). According to this estimate, yields undershot their fair value by about 100bp late last year and have since backed up above their current MS FAYRE value of 3.1%. So, most of the back-up in yields reflects a return to fair value rather than a surge to unsustainable highs. It is remarkable, though, that yields now exceed MS FAYRE for the first time since early 2004. Thus, the ‘conundrum' of bond yields trading below their fundamental values finally appears to have come to an end after more than five years. However, given the standard errors of our model, the current undervaluation of bonds is fairly small - fair values have tended to attract bond yields emphatically when the deviation has exceeded 100bp. *Worries about sovereign risk: *The other factor that has probably helped to push yields higher, especially recently, is worries about sovereign risk on the back of rapidly rising public sector debt in the US and elsewhere. We think it is important to keep in mind that in countries like the US where public debt is denominated in domestic currency, sovereign risk is really inflation risk (a point made in "The Global Liquidity Cycle Revisited", *The Global Monetary Analyst*, May 27). It is extremely unlikely that the US government would ever default, because it could simply instruct the central bank to print money to service and repay the debt, if needed, which would ultimately be inflationary. Bond markets understand this, and so it is wholly unsurprising that the rise in nominal yields has been more than fully driven by a rise in the inflation premium rather than a rise in real yields. While 10-year breakeven inflation rates have surged by about 200bp since the start of the year to some 2% now, real yields have actually declined by some 50bp. *Yield back-up to derail the recovery? *We think it unlikely that the rise in bond yields will derail the (tepid) recovery we anticipate for 2H09. This should be clear from the decomposition of nominal yields into real yields and inflation discussed above. What matters for the real economy are real interest rates, not nominal rates, and real interest rates have fallen rather than risen. In fact, the rise in inflation expectations could even provide some near-term support to demand as people may bring forward consumption in the expectation of rising prices. Put differently, late last year, when deflation fears were widespread, consumers probably held back in the expectation of lower prices. This is less likely to be the case now that inflation expectations have normalised. *How will central banks react?* In our view, the major central banks are more likely to see the back-up in bond yields as a sign of normalisation rather than something to worry about. After all, they resorted to unprecedented conventional and unconventional easing in response to the rising deflation threat. The fact that deflation fears have now abated (though not wholly disappeared) is therefore likely to be seen as a success. Also, despite the sharp rise, market-based inflation expectations are still at or even slightly below central banks' explicit or implicit inflation targets. Given the outlook for an only hesitant economic recovery later this year, the bond market sell-off is therefore unlikely to derail the QE programmes that are currently underway in the US and the UK and will be announced in more detail by the ECB on June 4. If anything, our US economists believe that the FOMC could decide to step up its purchases of government bonds and MBS at the June 23-24 FOMC meeting (see *Morgan Stanley Strategy Forum*, June 1). *What next for bond yields?* Despite the sharp sell-off in bond yields, we think yields will drift higher still over the medium term. Our US economics team looks for 10-year US Treasury yields to rise to and above 5% over the next 12 months. Also, our interest rate strategy team expects a further unwinding of the US bond bubble (see *Global Perspectives: Bonds: A Bursting Bubble?* May 29). As we see it, the inflation premium at close to 2% still looks very low, given the unprecedented monetary easing and the ongoing monetisation of government debt. At 2%, markets still expect CPI inflation to be lower on average over the next ten years than it has been over the last ten (2.5%). With more signs of economic healing to come and central banks not even halfway though with their announced QE programmes, we believe that there is ample scope for a further rise in inflation expectations over the medium term. Investors who share this view may want to refer to our strategists' publication referenced above for trade ideas based on this view. --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. 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