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The low yield puzzle

Gilt yields are lower than they should be, given the improvement in economic conditions.
The low yield puzzle
  • Bond yields are lower than we'd expect given that the economy is recovering.
  • This is because of the Fed's promise to hold interest rates down, which means bond prices could fall a lot if policy changes. 

Gilts have become less cyclical.

Usually, we see gilt yields rise during economic upturns as investors sell them in anticipation of higher inflation and interest rates and switch into assets such as equities which would benefit from economic growth. In recent months, however, this has not happened to the extent it usually does.

My chart shows this. It shows that from 2010 to 2020 there was a strong correlation between five-year yields and the manufacturing purchasing managers’ index (PMI), as measured by Markit. A stronger economy has meant higher yields and a weaker economy lower ones, just as you’d expect.

Since last summer, however, this link has broken down. Gilt yields have risen nothing like as much as you’d expect given the rise in the PMI. To roughly quantify this, if the 2010-19 relationship between yields and the PMI had continued, five-year yields would today be around 1.9 per cent. In fact, they are below 0.3 per cent.

It’s hard to attribute this decoupling to quantitative easing holding down yields. Previous doses of QE, in 2010-12 or 2016 – did not greatly disrupt the cyclicality of yields, so why should the latest dose have done so? The question is especially tricky because, as Christopher Martin at the University of Bath and Costas Milas at the University of Liverpool have argued, later doses of QE are less effective than earlier ones.

Nor is it easy to attribute it to the long-run global downtrend in yields caused by a combination of (among other things), the shortage of safe assets, falling profit rates, dearth of investment opportunities and slower economic growth. Certainly, there is such a trend. But there have also been cyclical ups and downs around it. The question is why the cyclical rise in yields has been so weak since last summer.

One possibility is that the PMI overstates the strength of the economy. It measures the proportion of companies enjoying increased activity, which means the index could be extraordinarily high even if lots of firms report only slight improvements.

Relatedly, markets are looking through a temporary rise in activity post-lockdown and are anticipating a return to normal, sluggish, growth rates soon.

But there’s something else going on. The puzzle depicted by my chart is not confined to the UK. The same thing has happened in the US, where yields have also risen only slightly since last summer in the face of a strong bounceback in economic activity.

A big reason for this is the Federal Reserve’s forward guidance on interest rates. It has promised to keep the fed funds rate near zero until it believes the economy has reached “maximum employment” and inflation looks like exceeding two per cent “for some time.” One reason why yields have fallen since April is that markets have been surprised by the Fed sticking to this promise in the face of rising inflation.

With the proportion of working-age people in jobs lower now than it was at any time between 1983 and 2019, and the Fed believing that current high inflation is only “transitory”, futures markets interpret this promise as meaning no rise in rates until late next year, and rates staying below one per cent until 2026. Because five-year yields are equal to the path of short rates which investors expect between now and 2026, this anchors US yields down. And because government bonds around developed economies are close substitutes for each other, this means low yields in the UK. The Bank of England’s belief that current above-target inflation “will be temporary” and thus that rates here won’t rise quickly is further holding gilt yields down.

All this, however, gives the Federal Reserve a problem: if inflation proves to be more than merely transitory, how does it unwind forward guidance without triggering a big rise in interest rate expectations and hence bond yields?

It has good reason to want to avoid doing so. Such a sell-off might well be accompanied by falling share prices as investors fear a possible reversal of the “reach for yield” that has led investors into equities not out of bullishness but merely from despair at the lack of return on cash. Such a double sell-off would mean a serious tightening of monetary conditions: both higher borrowing costs and mortgage rates, and an adverse wealth effect from falling share prices.

Avoiding this requires the Fed to adjust its guidance only gradually – although whether it can do so without unsettling markets is not known.

In this sense, critics of the Fed have a point when they claim that markets have become addicted to cheap money – because withdrawal from this fix will be painful if markets go cold turkey.