The first point to note is that it is not a severe one. Since 1990, the annualized volatility of weekly changes in ten- year gilt yields has been 0.96 percentage points. This means the half-point rise in yields in the last five months is not extraordinary. It's barely more than a one standard deviation event, a one-in-six chance.
As for why it's happened, there are (at least) five ways in which bond yields can rise. And it matters enormously which of these is at work. These are:
1. A fall in risk aversion, which causes investors to sell safer assets such as gilts.
2. A reduction in time preference, whereby investors prefer shorter-term assets such as cash to longer-dated bonds.
3. A bursting of a "bond bubble."
4. A fading away of the longish-term factors that have forced yields down over the last few years.
5. Fears about the creditworthiness of the government.
The bear market we've seen in recent weeks is type one - a fall in risk aversion. One big fact makes me say this – that share prices have risen: since August, the All-share index has risen by over five per cent.
This fact is inconsistent with most of the other types of bear market. If time preference had fallen, then share prices should also have fallen, because these, like bonds, are in effect long-dated assets; they offer cashflows in the distant future. If creditworthiness were in doubt, shares would have tumbled as markets feared even more austerity as the government tried to re-assert its "credibility". (We'd also have seen sterling fall in this event, which is something else that hasn't happened.) And if the "bond bubble" were bursting, there'd be no good reason for shares to rise and at least one – increased uncertainty about the investment climate – for them to fall.
Granted, one of the structural supports for low yields has also faded, so there's an element of factor 4 at play; the latest FOMC minutes show that the Fed is thinking about ending its bond purchases later this year, earlier than anticipated. However, this is partly reflects its belief that the economy is recovering, which is a reason why investors' risk aversion has declined.
In this sense, what we've seen so far is a "good" bear market in bonds – an increased appetite for risk that's driven share prices up.
One reason for this is that tail risk has declined. Investors are no longer so fearful of a catastrophic break-up of the euro, or of the US's "fiscal cliff" leading to recession. Demand for government bonds as insurance against disaster has therefore fallen.
However, I'm not sure this can continue. Yes, it will do so if the global economy picks up strongly. But it's not at all clear this will happen. Whilst last week's purchasing managers' surveys were mildly encouraging in the US, they showed only a moderation in the euro area's recession and were mixed in the UK; manufacturing was good but services poor. This is not a strong basis to expect a vigorous upturn. And in the absence of such an upturn, there'll be continued demand for bonds and thus a limit on how much further yields can rise.
In saying this, I don't deny that yields will probably rise over the next few years. This is what the market expects - the yield curve is upward-sloping – and it would be merely a return to normality. My point is rather that a quick and large rise in yields caused by continued falls in risk aversion requires signs of a strong global economic upturn. And it would be a surprise if such signs emerge soon.
