Is the three-and-a-half decade long bull market in the highest-rated government debt over? If so, would that be a good thing or a bad one? The answer to the first question is that it seems quite likely that the yield of 0.08 per cent (8 basis points) recorded on the 10-year Bund in April was a low point. The answer to the second question is that it would be a good thing: it would suggest confidence that the threats of deflation and eurozone disintegration are fading. At the same time, this bounce does not mean that a rapid rise in yields to what used to be normal levels is on the way. We should want to see yields rise, but modestly. This is also what we should expect.
Yields on 10-year bonds have behaved like the grand old Duke of York in the nursery rhyme: they marched right up to the top of the hill and then marched right down again. Yields on government bonds of the big advanced economies peaked in the early 1980s: Japan’s peak was near 10 per cent, Germany’s 11 per cent and those of the US and UK 15 per cent and 16 per cent. Then came a decline. Japan’s rates had fallen below 2 per cent by the late 1990s. Yields in the other three countries were between 3 and 6 per cent before the crisis, only to fall far lower still.
Theory suggests that long-term interest rates should be a weighted average of expected short-term interest rates, plus a “term premium”, as Ben Bernanke, former chairman of the Federal Reserve, argues in a recent blog. The premium should normally be positive, even in the absence of default risk. Longer-term securities are riskier than short-term ones, because their prices are volatile. Expected short-term rates should be determined by expected real interest rates and expected inflation. Again, expected domestic real interest rates should be determined by expected global real interest rates and expected changes in real exchange rates. Expected global real interest rates should, in turn, be determined by the expected balance of saving and investment. Finally, special factors, such as risk-aversion — at the limit, outright panic — and purchases by foreign governments and central banks, will also affect the prices of long-term bonds.
Most of what explains the collapse in bond yields (and so the rise in the prices of such bonds) is reasonably clear. Up to the mid-1990s, the dominant causal factor was the collapse in inflation. In Japan, deflation even became entrenched in the 2000s. From the late-1990s up to the crisis, the main explanation was a decline in long-term real interest rates from a little below 4 per cent to a little above 2 per cent, as shown in yields on the UK’s index-linked gilts.
Since the crisis, the dominant factor has been further marked declines in real interest rates. These are close to zero in the UK and US. In America and Britain people expect prices to keep rising modestly, in line with targets, though not in Japan. The European Central Bank’s recent policy measures are designed to keep inflation expectations up in the eurozone. Meanwhile, the risk premium can only be estimated. Over the long run, it has been volatile. Estimates from the New York Federal Reserve suggest it is now close to zero.
Many think purchases by central banks are the dominant cause of low yields. The evidence suggests this is untrue, though it has to be a factor. Far more important is the expectation that short-term rates will stay low.
Today, long-term bond yields in the UK and US are remarkably low, given their economic recoveries. One reason is a spillover from the developments in the eurozone. In recent years, the ECB has been successful in eliminating perceived risks of break-up. Its current programme of asset purchases and other measures have also lowered the general level of eurozone nominal yields. But a powerful safe-haven effect also operates, with shifts into Bunds and also Swiss (and other) bonds. Ten-year yields on Swiss bonds became negative when the currency was allowed to appreciate. Ten-year yields on Bunds effectively fell to near zero. (See chart.)
So what might happen now? The following points must be remembered.
First, nominal and real yields are very low in all the important high-income countries. Thus, they are vastly more likely to rise than fall from recent levels, unless sustained long-term growth and positive inflation are over.
Second, yields are astonishingly low in core European countries. If the ECB succeeds with its endeavours and so the recovery continues to gain pace, then yields should rise a great deal. The same should ultimately be true for Japan.
Third, post-crisis headwinds — among them, high levels of household debt — nevertheless are strong. Also important must be the economic slowdown in China. Thus, the equilibrium global real interest rate is likely to remain low by historical standards for quite a long time.
Fourth, sharp rises in expected short-term interest rates and so in long-term conventional yields are only likely to follow a strong recovery (which would drive up real yields) and so perhaps a strong rise in inflation expectations. This is possible. But it seems unlikely. Whether a big jump in yields would be a good thing depends mostly on whether it is driven by optimism about the real economy or pessimism about inflation.
Finally, falls in nominal and real yields below recent low levels would imply a descent into deflation. Central banks can and will prevent that; never say never, but this looks highly unlikely.
In short, the long fall and recent collapses in nominal and real yields on safe securities should now be at an end. One must hope so. Further declines would be highly disturbing. At the same time, a swift return towards levels considered normal before the crisis seems unlikely and would certainly create some instability. This might well be a turning point. But, given uncertainties, it would be best if yields turned slowly.