THE recent rise in bond yields has been particularly sharp since last week’s meeting of the US Federal Reserve. Although it has since fallen back, the yield on US ten-year Treasury notes reached near two-year highs of 2.66 per cent on Monday, against 1.66 per cent in early May. UK government bond yields have moved in virtual lockstep with their US counterparts. Why is this happening and what does it mean?
My belief is that we are witnessing a paradigm shift. The world’s central banks are beginning to lose control after more than four years of manipulating markets, with endless provision of liquidity through zero rates and quantitative easing (QE).
But let’s start with why QE doesn’t work. I have long stated that massive liquidity from central banks has only benefited 20 per cent of the economy. This is comprised of companies that are already large and profitable, and banks with good credit and political access. The premise for supporting these firms is the belief that rising asset prices creates a wealth effect – where a rise in spending accompanies an increase in perceived wealth. This is a myth that has been thoroughly debunked. Instead, central bank policies are subsidising the asset rich, while neglecting the majority of the economy that continues to suffer.
Indeed, as money printing merely pumps asset prices, rather than stimulating demand, the 80 per cent of the economy composed of productive, innovative, job-creating and less capital-intensive small and medium-sized firms is enjoying no net benefit. As this part of the economy remains starved of real demand and credit, the upshot is the current malaise of low growth and high unemployment.
Meanwhile, despite economic distress, we have seen little social discontent. This can only really be explained by the continued “success” of generous entitlement spending in developed economies. Apparently, those who receive transfer payments from the public purse are not compelled to challenge government and central bank policies. Given that approaching 50 per cent of the population benefits from income transfers directly from the state, the asset-rich are happy and the least well off are at least anaesthetised.
So why does a rise in bond yields upset the apple cart, and what will central banks do to counter the de facto tightening that higher yields bring to the economy?
The quick response might be more QE. After all, central bank QE programmes have been firmly in the driver’s seat since 2008 and have more or less achieved what they set out to do by suppressing bond yields and boosting asset prices. But the problem is that QE is now becoming too extreme, particularly in its latest Japanese incarnation – so-called Abenomics.
Instead of calming markets, the forcing of such massive liquidity into the Japanese market is making savers uncomfortable and has sparked a desperate rotation of assets. Bond holders are left wondering what they should do if the Bank of Japan actually succeeds in engineering two per cent inflation. Both bond and equity markets have suffered a massive acceleration in volatility. And when volatility comes back into play, asset price appreciation slows or reverses because perceived market risk rises and market participants deleverage. Effectively, we all discover that the huge increases in asset prices were merely a confidence game by central banks to begin with. The irony is endless – and QE eventually becomes self-defeating.
Adding to the risk of higher yields is the ongoing sharp contraction in the China-led mercantilist model. This saw export powers recycling their export revenues into deficit countries’ bonds. Japan is on the verge of becoming a current account deficit nation and China will likely follow as soon as next year. Thus, the largest buyers of government bonds over the last 20 years could soon become net sellers.
I expect that this general rise in yields will continue, as the recognition of the failure of QE spreads. This will mean a “normalisation of risk premiums”. This is healthy in the long term, as it encourages creative destruction in the economy by flushing out the inefficient and over-leveraged. Those individuals and companies found it too easy to refinance at ever easier terms, as QE suppressed yields.
A global rise in the bond yields will mean we are moving towards rediscovering the true cost of money. Both the private and public sectors will be forced into changing behaviour. This could put a pinch on the economy, on asset price appreciation, and on government spending – and therefore entitlements. But ultimately, it is clear that the implications of rising yields are important not just for markets, but for all of society as well.
Steen Jakobsen is chief economist at Saxo Bank.