Financial Times Editorial - Bond market sell-off is not the big one, yet

Bond market sell-off is not the big one, yet
Published: April 4 2006 03:00 | Last updated: April 4 2006 03:00. Copyright by The Financial Times

This year is shaping up to be a miserable one for bondholders. Yesterday's sell-off leaves investors nursing further losses after a first quarter in which the JP Morgan Global Bond index underperformed cash by 95 basis points. The good news for battered bondholders is that, at this point, the shift in the market looks cyclical rather than structural. The bad news is that this cyclical adjustment may have further to run. Moreover, if the structural underpinnings of today's low interest rate environment ever came under pressure, the resulting sell-off would make recent price falls look like a picnic.

Certainly, the pattern of interest rates now looks a little bit morenormal than it did when Alan Greenspan, the former chairman of the Federal Reserve, talked about a "conundrum" - long-term rates flat or falling while short-term rates went up. In retrospect, it is possible to split the Fed's tightening cycle into two stages. During the first stage, from June 30 2004 to June 2 2005, the Fed failed to gain traction in financial markets. Short-term policy rates rose, but long-term market rates fell: the 10-year rate declined from 4.61 per cent to 3.89 per cent. During the second phase from June 2 2005 onwards the Fed finally gained traction and long-term rates rose, with the 10-year rate touching 4.90 per cent yesterday.

Since the low in the early summer of last year, long-term US rates have risen relative to long-term rates in the UK, eurozone and Japan. But not by very much. The rise in bond yields has been a global phenomenon. This suggests growing confidence that the economic cycle is entering a new phase, defined by broader-based growth, a vanishing output gap and pre-emptive action against inflation risks.

Between June 2005 and today, the break-even inflation rate on 10-year US Treasuries increased to 2.52 per cent from 2.06 per cent. But, over the past month, the driving force has been rising real rates, not increasing fears of inflation. This reflects strong activity data and tough rhetoric from central bankers. The Bank of Japan and the European Central Bank look positively trigger-happy, while Ben Bernanke, the new Fed chairman, is correcting mistaken impressions that he would be soft on inflation.

Even so, long-term rates remain remarkably low by historic standards. At this stage in the cycle, long-term yields have typically been at least 100 basis points higher. This is probably because, while cyclical influences have changed, the underlying causes of low long-term rates remain largely in place: a surplus of desired savings over desired investment in emerging markets, high corporate saving globally, plus recycling of reserves into mostly US bonds. This constellation of forces could remain in place for some time. But probably not forever. The day they start to shift is the day the bond market will really be in trouble.