Global bond markets have been in a bubble for so long that many participants are in danger of forgetting it exists. Some recent investment decisions can only be rationalised on the basis of a belief in perpetually low and stable bond yields. To the extent that such expectations are extant, they are likely to be disabused over the next year or so.

We need to recall that over the past five years, bond markets have exhibited a significant change in the way they react to economic fundamentals. Relative to comparable points in past economic cycles, bond yields are now much lower and yield curves much flatter than would typically be the case. Since both central banks and bond investors respond in a predictable manner to economic fundamentals, this change of bond market behaviour can be quantified with some precision. Predictability of response allows us to use econometric techniques to model short and long-term interest rates. These models show us that while short-term or official policy rates are more or less where they should be, given the current economic environment, longer-term interest rates are around one percentage point below their equilibrium value.