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

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.