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OPINION

Escaping negative yields

Escaping negative yields
April 10, 2017
Escaping negative yields

Such low yields are especially remarkable because two things have happened in recent months that should have raised them.

One is that global investors' appetite for risk has increased. MSCI's index of world share prices has risen 14 per cent in US dollar terms in the last 12 months, fuelled in part by what Ethan Harris at Bank of America Merrill Lynch calls a "synchronised surge" in global output.

The other is that investors have dumped US Treasury bonds. Official figures show that foreign investors sold almost $300bn of them in the 12 months to January. Rather than being the trigger for a worldwide rise in yields, however, this selling was merely part of a shift into other government bonds.

Why have yields stayed low in the face of these pressures? One useful mental model here is to think of index-linked yields as a residual. Conventional gilt yields are set by overseas yields plus a currency risk premium; inflation expectations (and inflation risk) are deducted from this; and what's left are index-linked yields.

Two big things are holding down conventional yields. One is huge worldwide demand for safe assets. This isn't merely due to the fragility of western economies and the scarring effect of the financial crisis. It's also because Asian, Middle Eastern and Russian investors have few secure domestic assets and so buy western bonds as a safe haven.

The other is that eurozone short-term interest rates are expected to stay negative for another two years: futures markets don't expect the three-month euribor rate to turn positive until late 2019. This is holding down eurozone government bond yields simply because these are equal to the expected path of short-term rates. And this in turn means low UK yields.

When low conventional yields combine with an expectation for annual RPI inflation to average almost 3 per cent over the next five years, the upshot is record-low real yields.

What, therefore, might change to raise real yields?

For me, the likeliest candidate lies overseas. If economic growth continues to exceed expectations investors will revise up their expected path of short-term rates in the US and eurozone, prompting a rise in conventional yields. This, however, is only a possibility and not a certainty. The fact is that there are deep structural reasons for negative real yields that won't disappear quickly.