What is driving bond yields?

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What is behind the recent concerted rise in global government bond yields? Is it fear of inflation, a return of the traditional term premium, or a reflection of stronger-than-expected growth? What do higher yields mean for mortgage borrowers, stock markets and the credit environment? Where do yields go from here? Jack Malvey, Lehman Brothers’ chief global fixed-income strategist, answers your questions on FT.com.

”This ’early June swoon’ serves as useful reminder of the fragility of assumptions, even imagined long-held axioms such as endless low rates/inflation,” he says. ”Bottom line, the late-cyclical disease of complacency has tripped up many a stellar long-term portfolio performance record.”

What type of reallocation do you expect (considering higher yields in a stronger economy) going forward out of yield stocks (sa utilities and reits) and into treasuries and late cycle growth stocks (ie technology)?
Paul Leddy

Jack Malvey: As a debt strategist, I’m afraid that I do not cover individual equity sectors. From my bond corner, I’d caution about taking this recent modest repricing of debt too far in terms of ultimate peaks in calibrating equity strategy. Most of global yield curve normalisation since 2003 already has taken place. Come 2008, markets likely will be looking for major central banks, particularly the Fed, to ease somewhat.

Rising bond yields are part of the recovery from the artificially low interest rates introduced by central banks after September 11th 2001. Would you agree with this assertion?
Ian Slater, Stafford

Jack Malvey: Partially. Many factors drive global rates down over 2001-2003. September 11 and terrorism risk played a role. The global economy also slumped, even prior to September 11. Capital market confidence also was hurt by concerns over corporate governance. And the New Paradigm, dotcom mania of the late 1990s came to an end in 2000, to the detriment of equity returns over 2000-2003. Since the Great Central Bank tightening cycle began in 2003, global interest rates indeed have gravitated higher to more ”normalised levels.”

Of energy, agriculture, base metals and worker shortages; which do you think poses the greatest threat to inflation and will put the greatest pressure on bonds?
David Meyers, Vancouver

Jack Malvey: Energy. Although less of a factor of GDP production than in the 1970s, another sharp swell in energy prices would have a greater effect on realised inflation and especially the psychology of inflation expectations for businesses and consumers than agriculture, base metals, and labour availability. Energy figures in nearly all economic activity.

In contrast, not every industry and consumer is attuned to fluctuations in agricultural and industrial metals prices.

What was the trigger for the sudden move and is the current yield curve stable?
Robert Davies, Glasgow, UK

Jack Malvey: There were multiple triggers for this recent rising tide in global rates. Some forecasters and institutions abandoned their long-held expectations of near-term Fed rate ease. The US housing correction headwinds do not appear sufficient to trip the US economy into a recession. World economic growth generally continues to surprise slightly on the upside.

The supply of fixed income debt has increased; this could could be record year for gross origination. Asset-liability managers had to sell Treasuries to adjust the duration of their liabilities to the rise in duration of their MBS holdings. European and Asian rates likely will rise somewhat as their central banks complete tightening cycles during the second half of 2007. Although minor bouts of higher US rates cannot be excluded over the balance of 2007, the US curve may prove more stable and range-bound with a Fed expected to remain on the sidelines well into 2008.

Does it make sense to remove energy from inflation calculations on the grounds of volatility? The price of oil looks set to remain where it is plus or minus 10-15 per cent. With this in mind, is it time to invest heavily in TIPS now they have fallen in price? Do you have an opinion about inflation bond funds? I am thinking of buying FFGPX but it is very small and wonder if this is a good plan.
Jeffrey Fessel MD, San Francisco

Jack Malvey: Inflation can be looked at many different ways. The inclusion or exclusion of more volatile components, like food and energy, has been well debated over the past three decades. Our simple recommendation: look at both and form your own view. Inflation-linked securities should be a part of most institutional and high net worth portfolios.

The ultimate allocation decision depends upon portfolio investment goals, constraints, and risk tolerance. Remember: inflation-linked securities do provide protection against rising inflation but at the cost of likely lower long-run returns than other financial asset classes.

With the apparent bull market of bonds over, what is the future of fixed-income and fixed-income firms? Will they keep move away from bonds and move more into FX/Derivatives/Preferred/et al?
Dennis Klarta

Jack Malvey: In terms of size, the global debt capital markets have been and likely will continue to grow at a rate of about 10 per cent per annum for the foreseeable future. The fuller integration of EM economies, especially in Asia, into the world capital markets might drive this growth higher over the next 10-15 years.

Meanwhile, derivatives have growing a double-digit plus pace for the past 30 years. In particular, see the amazing growth of credit derivatives over this decade, from virtually nothing to about $26,000bn outstanding. Accordingly, the future of fixed income and fixed-income firms looks very bright. This is a growth industry.

Have you noticed decreasing appetite for US T- bills from Asian and Middle East governments? Is this going to affect yields?
Titas Sereika, Italy

Jack Malvey: Over the past several years, some central banks and other official government asset management organisations have professed a desire to diversify their holdings away from US fixed-income securities. In turn, they have very gradually increased their preference for non-US debt, while still buying large amounts of US debt securities.

There does not appear to be a meaningful change underway in this very gradual, strategic trend over the course of 2007. If such institutions radically reduced US debt acquisition, which seems unlikely, this would push US yields higher.

It doesn’t seem that the markets in the US have fully absorbed the higher bond yields or was the recent slide and the subsequent run to the upside (14 June and 15 June) an indication of the markets true strength and ability to digest the uptick in bond yields?
Frank Pullo, Seattle

Jack Malvey: Although the global capital markets again were challenged in early June by an outbreak of inflation concern and sharp upward re-pricing of debt capital costs, strong global fundamentals and sustained high liquidity quickly persuaded the markets that this latest ”Risk Flare” again would be brief.

What impact will rising domestic bond yields have on emerging market debt? How strong is the correlation?
Simon Chu

Jack Malvey: The modest increases in global debt yields so far will have a negligible effect on the relative performance of emerging-market debt. The US and Japanese yield curves were in the same neighbourhood a year ago as today without mishap to the EM debt market. If major global benchmark curves were to undergo a major sell-off, pushing interest rates 100-200 bp higher (not our expectation), then there would likely be some substitution of plain-vanilla local currency treasury obligations to the performance disadvantage of EM debt.

The precise correlation varies through time and depends upon many factors, with the absolute level of yields being subordinate to the overall state of the global business, cycle, general capital market liquidity, spreads, etc.

What stage do you think is US economy in? Is inflation a matter of concern in the short run or long run?

Jack Malvey: Probably similar in ultimate length to its 1980s and 1990s business-cycle predecessors, the US economy is slightly more than halfway through another 8-10 year expansion. The last US recession ended officially in November 2001. The next US recession may arrive sometime between 2009-2012.

Inflation risk is always a concern to capital markets, especially for bondholders. Although measures of core US inflation actually have descended a bit lately, the combination of a vigorous global economy and commodity price escalation have engendered some concern about the strategic risk of rising inflation expectations. A return of the sharp inflation rise of the 1970s is very unlikely. But the ”deflation thesis” in the early Oughts has been retired.


Mr Malvey, a well-known figure on Wall Street, joined Lehman in 1992 after stints at Kidder Peabody and Moody’s Investor Services. In addition to holding the Chartered Financial Analyst designation, he is a former president of the Fixed Income Analysts Society and was inducted into the Fixed Income Analysts Society’s Hall of Fame in November 2003.

For the past 15 consecutive years, Mr Malvey has been a first-team bond strategist in Institutional Investor’s annual fixed-income research survey.

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