Good news behind higher bond yields - Financial Times

5/2/2018

Good news behind higher bond yields

Despite a risk of a disorderly sell-off, yields are rising because of faster growth and inflation

Mohamed El-Erian

For something that supposedly was predicted for so long, the move up in US interest rates has attracted lots of attention. It’s been blamed for a violent sell-off in stocks and fuelled warnings not just of an end to the bull market in bonds but, perhaps, also equities. That, in turn, can engender concerns about the housing market, corporate funding, financial stability and economic growth.

Yet the causes behind the rise in bond yields suggests this is more likely to be part of a larger — and healthier — economic and financial normalisation. It is one, as I argued last month, that could help America and other advanced countries confine to the rear-view mirror the years of being stuck in low and insufficiently inclusive growth.

There are four reasons why.

First, the move up in yields is not just a US issue: it is part of a wider phenomenon that has seen German government bonds largely keep pace with their American counterparts. Five-year German maturities escaped the negative rate world they have been mired in for several years. It has also helped moderate a flattening of the yield curve that had led some to incorrectly argue markets were signalling an upcoming derailment of economic growth.

Second, and more importantly, good (not bad) forces are driving this phenomenon. Rather than a monetary policy mistake or deteriorating perception of sovereign credit risk, higher yields reflect increasing comfort with the growth and inflation outlook. The US is part of a synchronised pick-up in global economic activity, turbocharged by the implementation of pro-growth fiscal measures and deregulation, as well as brighter prospects for an infrastructure boost. Meanwhile, as confirmed by last week’s meeting of Federal Reserve policymakers, the US central bank continues the “beautiful normalisation” of unconventional measures, with markets converging much faster this year to official policy guidance on policy rates and inflation.

Third, despite the move up this year, rates remain at historically low levels, according to many metrics. They are well below what would normally be associated with the current — as well as forecast — growth and inflation, and what would be predicted by historical correlations for asset classes. Recall that last year the yield on US 10-year government bonds declined despite the surge in stocks that saw the S&P 500 rise 20 per cent.

Finally, it is far from clear the move in yields is necessarily the beginning of a larger and disorderly repricing of fixed-income markets. Recent comments by Bank of Japan governor Haruhiko Kuroda and his European Central Bank counterpart Mario Draghi suggest that, despite improving domestic economies, neither central bank appears in a particular hurry to halt unconventional support of asset markets.

Moreover, with the 2017 sharp rise in equity prices having enhanced the funding status of so many public and private pension funds, the inclination and ability to “immunise” their liabilities is significantly stronger. The recent rise in rates, together with the wake-up call of the stock sell-off, will encourage more of them to step up their purchase of longer dated fixed income securities to match the maturity of future payment promises.

Taking these four points together suggests a much stronger likelihood that higher rates are part of a new and better economic paradigm for advanced countries. It doesn’t mean that there won’t be pain or that some other markets will not need to reprice. And there are, of course, still risks to durable growth and financial stability.

Tighter and more volatile financial conditions will increase the cost of mortgages and funding for corporations, and make life less comfortable for certain sectors of the economy such as interest-rate sensitive home builders and home improvement companies.

The development also comes at a time in which the funding needs of the US government are going up. But from a broader economic perspective — and as long as advanced economies continue to avoid geopolitical shocks, policy mistakes and market accidents — such drawbacks will pale next to the benefits of stronger and more-inclusive growth powered by higher business investment and rising household incomes.

This will also help counter the risk of collateral damage that has come with prolonged reliance on unusual central bank intervention in markets. In Europe’s case, for example, it has included negative nominal rates that eat away at the structural integrity of markets and undermine the provision of long-term protection such as life insurance and retirement products.

Given the dominance in 2017 of unusually low volatility and extremely favourable price performance, it should come as no great surprise that the market sell-off is attracting so much attention.

Yet it is the investor conditioning that was fuelled by last year’s benign developments that helped increase the technical probability of a sudden air pocket. With underlying fundamentals continuing to improve, the risks of disorderly spillovers to the economy and the financial system as a whole are likely to be well contained.