Are We All Behind the Curve? What Are Bonds Telling?

by Michael J. Howell14. January 2014 08:25
The medium-term yield component of long-term bond yields has been rapidly expanding – we measure this by ‘bootstrapping’ the implied 5-year yields, 5-years out (or 5s at 5).This implied forward yield, or ‘core’ yield, is the major influence on the more widely-quoted 10- year spot rate, the traditional bond benchmark. Think of these spot yields as comprising 'core' component, refecting economics, and a short-term premium or discount measuring the effect of monetary policy. The 'core' component provides the most efficient guide to where future spot yields will settle as roll-down effects dissipate. In the past six months, US 5s at 5 moved up by 60bp to 4.26% and they stand at a 127bp yield premium to spot 10-year Treasuries. In Germany, the 5s at 5 yield rose by 49bp over the period to 3.27%, or a 116bp yield premium to 10-year Bunds. For the UK, the equivalent 5s at 5 yield hit 4.32%, up 48bp in six months, and also sit at 116bp premium to 10-year Gilts. Only in Japan did 5s at 5 fall (by 15bp) to 1.23%, although they are at a 49bp yield premium to 10-year JGBs. The 5s at 5 component is rising both faster than 10-year spot yields and is doing so because of increasing real interest rates. In turn, this may be because the marginal return on industrial capital is itself expanding once again, which we ascribe both to DM cyclical economic recovery and to the structural slowdown in China. The bottom line is that bond yields are not only rising faster than investors think, but the structure of forward rates tells us that they have already risen a lot. As we argue in a report published today, most investors are behind the curve.

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Watch Bonds

by Michael J. Howell21. June 2013 08:19
Bond markets nearly always give more sober assessments than equities. The movements in global fixed income markets in the past two months have it right again. QE or simply more liquidity drive up the risk premia on long-dated bonds (the low risk asset) and drive down the risk premia elsewhere. This is Liquidity Theory 101. If policy-makers anchor the short-end (they do) this beomes a bear steepening. The Central Banks pumping in most liquidity, the Japanese and the US, see the greatest yield curve steepening and those pumping least,the ECB, suffer the least (Bunds). On top, think about real interest rates. These are rising in anticipation of better economic growth in the second half 2013 and, if we are correct, stronger capex. The rise is connected to the end of the Great China Cost Shock we have written much about. This will push up marginal returns on capital and cause real rates to rise. 4-5% bond yields are again on the horizon. This is bullish for everyone else!

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