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OPINION

The bond sell-off puzzle

The bond sell-off puzzle
May 20, 2015
The bond sell-off puzzle

Since 20 April, 10-year gilt yields have risen by 0.4 percentage points, from 1.7 to 2.1 per cent, whilst 10-year index-linked yields have risen 0.25 percentage points, from minus 1.1 to minus 0.85 per cent. Most of the sell-off, therefore, has been real rather than nominal.

But the economic data doesn't seem to justify this. News about real growth has been mixed. Although eurozone GDP figures suggest the region is recovering, the Bank of England has revised down its growth forecasts and US figures show a drop in both industrial production and consumer confidence. Someone who looked only at news about the real economy in the last month would not guess that there's been a rise in real yields.

But inflation news has justified higher nominal yields; the eurozone has pulled out of deflation and the S&P/GSCI index of commodity prices has risen almost 5 per cent since 20 April. The economic data, therefore, suggest we should have seen a rise in nominal more than real yields. But we haven't. Why?

One reason is that the sell-off in bonds hasn't been due merely to macroeconomic developments. Instead, says Societe Generale's Patrick Legland, "the correction was mainly driven by technicals". Bonds were - we now know - overbought in mid-April with the result that since then there have been more marginal sellers than buyers.

This matters because bond sell-offs are often indiscriminate between real and nominal yields. Movements in the two are highly correlated: since January 2000 the correlation coefficient between monthly changes in 10-year conventional and index-linked yields has been 0.48. This tells us that it is common for real yields to rise when nominal ones do; the two assets are closer substitutes than the macroeconomic fundamentals would imply.

There's more. Asset prices don't change merely because of what happens. They also move because of changes in perceived probabilities. With the prospect of sustained deflation receding, investors have reduced the probability they attach to scenarios in which real and nominal yields collapse as central banks try to reflate their economies.

In this sense, the sell-off might not be a portent of stronger economic growth so much as a sign that the perceived downside risk to that growth has slightly diminished. It's far from obvious that this is any cause for concern, or any reason to change one's asset allocation.