Stephen King: Reading the runes of bond market uncertainty

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I have a little conundrum for you. If rising long-term bond yields are the mechanism by which an economy slows down, why is it that bond yields ever rise? Investors in bond markets are supposed to be forward-looking. They're supposed to anticipate the main economic risks lying in the road ahead and adjust their demand for bonds accordingly. So, if a slowdown is ultimately needed, bond yields should fall to reflect weaker growth prospects. But if bond yields fall, an economic slowdown would appear to be less likely.

US bond yields have risen quite a long way this year, seemingly telling us either that growth prospects have improved or that inflation prospects have deteriorated (see left-hand chart). Yet, at the same time, many commentators - myself included - have argued that US growth, in particular, cannot continue at its current pace, because debt levels would rise to silly levels and because the current account deficit would become excessively burdensome. If, however, US growth has to slow, bond yields should fall to anticipate the slowdown: and, if they do fall, the chances of a slowdown would appear to be reduced.

What I've described fits the story of the US recovery to date rather well. Persistently lower bond yields relative to financial market expectations have helped ensure that US consumers have carried on borrowing. As a result, US domestic demand has expanded at a reasonably robust pace, leaving GDP growth well supported despite an ever-widening current account deficit (which, for the record, tipped the scales at more than 6 per cent of US GDP in the final quarter of 2004, the biggest ever).

This description may also help to explain the, to date, rather ineffective impact of changes in US monetary policy. The Federal Reserve has been raising Fed funds, its key policy interest rate, since the summer, yet there are few signs as yet of the economy wanting to slow down. With the rise in policy rates making little difference to long-term interest rates, homeowners have continued to refinance their mortgages at lower bond yields, allowing money to be released to keep consumer spending bubbling away.

The rise in bond yields puts a slightly different gloss on the story. Three factors probably help to explain the change. First, inflationary concerns have risen as the latest US inflation data have come in stronger than expected. Second, the Fed's monetary language appears to be changing. The Federal Open Markets Committee still talks about raising interest rates in a "measured" fashion but its worries about inflation appear to have increased, enough to send a shiver down the collective spine of bond investors. Third, financial markets are fretting over the possibility of changed monetary regimes in Asia: greater exchange rate flexibility in those parts might reduce the scale of intervention flows that, to date, have kept the US bond market well supported and have prevented the dollar from heading into free fall.

Of course, the increase in bond yields hasn't taken yields outside of the range that's prevailed since the second half of 2002, so at this stage there seems little to worry about unduly. However, if bond yields continue to rise, they may be signalling some sort of change in the global economic environment.

The knee-jerk reaction is to become fearful of inflation. As I argued in last week's column, some of the early-warning indicators of higher inflation - rising commodity prices, for example - may overstate the underlying risk of higher inflation, particularly given the weakness of labour costs. However, whether or not that view is correct, any evidence of rising inflationary pressures is likely to make bond holders more nervous, thereby driving bond yields up.

But a past example suggests that rising bond yields and initially rising inflationary fears can sometimes send completely the wrong message about the underlying risks facing an economy. Japan's equity bubble burst at the end of 1989, heralding a bear market in equities that still hasn't drawn to an obvious close.

Yet, when Japanese equities first began to fall, the major concern for Japanese investors, oddly enough, was inflation. Bond yields were already rising in 1989 but reached new highs in 1990 (see right-hand chart). The Bank of Japan made its own contribution to the rise in bond yields, keeping short-term interest rates up at high levels to ensure that the bubble would never come back. But, regardless of the Bank's actions, financial markets were virtually paralysed by inflationary fears.

The rise in inflation expectations was ultimately, of course, telling us that the economy had to slow. And, because of that, equities weren't the only casualty of the post-bubble environment. Eventually land prices began to fall as well. As they did, the foundations of Japan's economic success in the 1980s were found to be built on no more than sand. The growth rate faded, risk appetite collapsed, inflation began to fall and was eventually replaced by deflation. Yet the Japanese bond market was never able properly to anticipate this change in fortunes: bond yields eventually did come back down again, but only alongside declining inflationary pressures.

This episode has been of considerable interest to the Fed. In 2002, it published a paper called Preventing Deflation: Lessons from Japan's Experience in the 1990s, noting that Japan's failure to deal with deflation was partly because both the authorities and the markets never saw it coming. Their persistent worries about inflation meant they were singularly poorly placed to deal with deflation when it arrived.

Why did the Japanese get it wrong? The main reason, I suspect, is that at any point in time we're never sure about the right economic model to use. An economy that's been growing strongly and is beginning to show signs of inflationary excess certainly needs to slow down. How far an economy will slow down, though, will depend on the ability of policymakers to manage market expectations, the extent to which inflationary expectations are entrenched (the more they are, the more painful the adjustment will have to be) and the degree to which leverage has been built up on the back of an overly optimistic view about economic sustainability.

In Japan's case, the Bank of Japan may subsequently have been heavily criticised but, at the time, it was doing no more than the private sector expected of it. Inflationary expectations were probably not particularly entrenched. But the bubble period had certainly fostered the illusion of an ongoing period of economic success, an illusion that could never be justified. The build up of inflationary fears was just one more sign that the bubble economy was just that: a bubble that could not be sustained.

Rising bond yields may be telling us that we're on the verge of a sustained increase in inflation, posing a threat to the credibility of central banks. However, Japan's experience provides a useful cross-check on this conventional wisdom. Concerns about higher inflation back then were, in reality, concerns about an end to the good old days. As the economic expansion fragmented, so risky assets fell in value. In time the economy stagnated, marking the beginnings of one of the greatest bond market bull runs the world has ever seen. It may well be that inflationary concerns are on the rise. But those concerns may simply be telling us that America's leveraged expansion is finally approaching its sell-by date.

Stephen King is managing director of economics at HSBC