Stephen King: Deflation fears mean bond sell-off may be premature

The outlook for US economic growth over the next year or so has deteriorated, not improved

"AAAAGHHH!!!" No, it's not the return of the flesh-eating zombies. For the majority of investors, it's something far worse - a sudden sell-off in bond markets. A few weeks ago, bond yields had fallen to remarkably low levels. Ten-year Treasury yields in the US, for example, dropped to 3.1 per cent, down from 4.0 per cent only six weeks before (see left-hand chart). Since then, however, they've gone back up again, if anything more dramatically than their initial decline. At the time of writing, the very same bonds had seen yields going all the way up to 3.7 per cent: those that bought at 3.1 per cent will be nursing some rather heavy losses.

The story isn't just restricted to the US. Yields have gone up virtually everywhere else. One country, in particular, has provided a potentially frightening message to bond investors the world over. Japan has seen a dramatic rise in yields in recent days, up from a low of 0.4 per cent to well over 1 per cent. Japan, the home of deflation, the country of ongoing recession, is selling bonds with gay - or should that be miserable? - abandon. If bonds aren't safe in Japan, heaven help the rest of us.

So, what's going on? The simple answer is to say that the world is about to pull itself out of stagnation, heading rapidly towards recovery and higher inflation. This view is supported not just by the sell-off in bonds but also by the, admittedly volatile, rise in the value of equities. If economies are recovering, equities are a far better bet: rising company profits will reward equity holders and faster growth will make bonds less attractive. Put another way, who would want to own a bond with a yield of less than 4 per cent (or, indeed, less than 5 per cent) if the consensus view about the US economy - which predicts growth of more than 3.5 per cent next year with inflation only a little under 2 per cent - is about right?

All fair enough. But hang on a minute. What happened to all those fears of deflation? What happened to those worries about the lack of a Baghdad bounce? What happened to the Federal Reserve's concern that inflation could be too low rather than too high? Have we said goodbye to all these fears? If we have, then it's been a remarkably quick turnaround. After all, these were the fears dominating markets only a few weeks ago. So what's really changed?

In my view, there is nothing in the data that justifies such a radical shift in perceptions about the economic environment. There have been a few stronger numbers here and there but, for the most part, the stagnation story seems still to be intact. Thursday's US data are a case in point: big increases in unemployment and other signs of ongoing labour market weakness. The plus point on Thursday was the survey of activity within services (the so-called non-manufacturing ISM), which came in a lot stronger than expected. But the equivalent manufacturing survey, released earlier in the week, was weaker than expected - as were the equivalent numbers through much of Europe. Nothing overly convincing, then, about an aggressive turnaround in economic activity.

In any case, you might have thought that markets would have learnt their lesson from the first half of 2002. Back then, people were absolutely convinced that recovery was on track, helped along by a pick-up in global business surveys far more impressive than the signals we've seen more recently. Yet rather than enjoying a healthy rebound in the second half of 2002, activity slumped once again, leading to a totally unexpected further round of interest rate cuts.

No, to explain what's been happening in the bond market we have to delve a little deeper. And to do this we have to go back to what the Federal Reserve said in its policy statement after its May Federal Open Markets Committee meeting and what it subsequently delivered following its policy meeting in June. In May, the Fed indicated that inflation might be too low rather than too high. For the markets, the Fed appeared to be highlighting the risk of deflation. In my view, this was absolutely the right interpretation: inflation that's too low leads to an unexpected rise in real debt levels that can be near enough impossible for a central bank to correct if interest rates are already rather too close to zero.

So the Fed appeared to be saying, "We recognise the risk, and we will do something about it." That, in turn, gave the markets the impression that not only would short-term interest rates come down, but also that the Fed might choose to use so-called unconventional policies, notably manipulation of long-term interest rates. Bond markets went wild.

In the event, however, the Fed failed to deliver. No, that's too harsh: it did, after all, cut short-term interest rates by 0.25 per cent. Bear in mind that, earlier in the year, the markets seemed fairly sure that we'd seen the last of interest rate cuts and that, at some point in 2003, rates might be heading up again - a view remarkably similar to that seen in the first half of 2002. Nevertheless, the Fed did fail to make any reference to unconventionality. And with that, the rug was taken from under the feet of the bond market and it promptly fell over.

This is all rather worrying. It shows either that the Fed mismanaged expectations or, alternatively, that the market has become incredibly fickle. What to say now? To my mind, there are two alternative views.

The first view, driven by gains in the equity market and not much else besides, is that the global economy really is on the brink of recovery and that investors are sensibly switching out of low-risk assets that provide protection against deflation into higher-risk assets that will more easily be able to ride the wave of economic improvement.

The second view, driven by falls in the bond market and not much else besides, is that the cost of borrowing for a large swath of American homebuyers has suddenly gone up, in effect reversing the consumer stimulus that has kept America's head above water over the past two years. In this scenario, the outlook for US economic growth over the next year or so has deteriorated, not improved.

Ultimately, I suspect that the second of these two options is nearer the truth. There is no real evidence of decent economic recovery. The news in the US remains poor, and developments elsewhere in the world fail to inspire. If so, the Fed may eventually have to put its money where its mouth is (or was). The last thing the Fed needs now is a major bond sell-off. Could it be time finally to dust off those unconventional policies, making sure that bond yields fall to levels that the Fed might believe would ultimately be consistent with sustained recovery? After all, if the Fed doesn't do so, the economy will only weaken further, eventually delivering the bond yield levels that the Fed could choose to deliver tomorrow.

Stephen King is managing director of economics at HSBC