So far, so good, for equity investors at least. Government bonds yields may be soaring around the globe but they have yet to derail the stock market rally which started in March. But how much longer can this continue? At what point will it become a problem? Government bonds have suffered a terrible 2009. Ten-year US Treasury and UK gilt yields are both close to 4 per cent, having started the year at 2.22 per cent and 3.01 per cent respectively, even though their central banks have engaged in quantitative easing programmes.
They are the worst performing asset class this year and the sell-off in US Treasuries has been as big as that in 1994.
The big fear among investors is that the rising bond yields will short-circuit the economic recovery by raising mortgage and corporate borrowing rates, at a time when consumers and companies are not ready to cope with higher bills. Indeed, the US 30-year mortgage coupons are now over 5 per cent and this is already affecting refinancing applications.
However, there are reasons for thinking such concerns have been overplayed. First things need to be put in perspective. In spite of their dismal performance, government bond yields are at historically low levels. Ten-year US Treasuries have averaged 4.5 per cent this decade and more than 7 per cent since 1980, according to Citigroup.
And second, one has to consider why yields have risen so quickly. Broadly speaking their are four explanations, according to Morgan Stanley. A more optimistic outlook for economic growth, inflation concerns, fears about massive government bond issuance and improving risk appetite.
They have all played their part in the back-up in bond yields. Traders say that yields first started rising as the flight to safety ended. They continued higher as investors started to price in the huge increase in government bond supply needed to fund record peacetime fiscal deficits. The latest gains are down to investors pricing in stronger economic growth and higher inflation – no bad thing for equity markets.
Robert Buckland, of Citigroup, says increases in bond yields from low levels are associated typically with improving risk appetites and rising growth expectations. In such scenarios, what is bad for bonds is good for equities.
However, this correlation breaks down when bonds start rising from high levels, as they did in 1994, when the bond market imploded and global equities flatlined.
“At these [higher] levels, risk appetites and growth expectations are already high and will not be able to counter rising bond yields. Rather, higher bond yields may be a prelude to tighter policy and lower growth expectations,” he says. Buckland believes the correlation between equities and bonds will remain negative until US 10-year yields approach 5-6 per cent and the UK gilts 6 per cent.
Of course, it is by no means possible that yields won’t approach 5 or 6 per cent, given the scale of the government funding programmes – the UK Debt Management Office is planning to issue £225bn in debt this financial year – and the fact that the oil price is now above $70 a barrel. Indeed, the US Treasury had to offer investors a yield of 3.99 per cent to get a $19bn issue of 10-year notes away this week.
And it is not just at the long end where yields are rising. As markets have begun to anticipate US interest rate rises by the end of the year, the yield on two-year notes have started rising. But as with bond yields this is from an extremely low level and should not unduly concern equity markets at the moment.
For the time being then, there is little to worry about for rising sovereign yields, given that the gains seem to be driven mainly by improved risk appetite and the better economic outlook. However, the situation is finely balanced and equity investors will continue to look nervously at events in the government bond market. A couple of tepid bond auctions would certainly test resolve.
Get alerts on Central banks when a new story is published