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Global Markets Weekly - 1 June 2009

• During the recent equity rally, yields on government bonds rose.
  Equity markets kept moving broadly sideways last week, with the most interesting developments instead coming in bond markets. In the recent equity rally, government bonds were negatively correlated with riskier assets: as equities rose and credit spreads narrowed, government bonds fell in value. Investors’ inflation expectations changed little during the rally. So, until recently, this was an unambiguously ‘good’ sell-off in government bonds, as increasing confidence was pushing capital towards riskier assets and thus increasing real yields. 
• Crucially, however, mortgage rates remained low, as spreads narrowed.
  Higher government bond yields were not even seen as a problem by the Federal Reserve (Fed), despite its policy of using quantitative easing (QE) to control longer-term rates. The interest rate that matters most to the US economy, and which Fed policy is principally directed at, is the mortgage rate. Although Treasury yields have increased since March, mortgage rates have remained in a tight channel for most of 2009, thanks to rapidly declining mortgage spreads. By last week, the spread between mortgage bonds and Treasuries was the tightest for 13 years.
• Yet bond yields are now rising even as equities remain level...
  With spreads so tight and the improvement in risk sentiment showing signs of abating, mortgage rates became vulnerable to further rises in government bond yields. Over the past two weeks, government bond yields have indeed risen, breaking the negative correlation between bonds and equities. If we were to identify a single trigger for this change in behaviour, the most likely candidate is Standard & Poor’s placing of the UK’s AAA credit rating on negative outlook. That led to a series of ‘are we next?’ scares in government bond markets, including US Treasuries.
• ...and that has started to drive up mortgage rates.
  So rising government bond yields are no longer a positive reflection of greater investor confidence. The most important result of this changed relationship has been the rise in mortgage rates.
• This process could become self-reinforcing, driving yields up further.
  The US mortgage bond market is around twice as big as the Treasuries market, and many of these bonds are held by institutions that have duration targets for their bond portfolios. As mortgage rates rise, refinancing existing home loans becomes less attractive to households. That reduces pre-payment risk, driving up the expected duration of mortgage bond portfolios. In order to control their duration exposure, mortgage bondholders sell their more liquid Treasury holdings. Hence, we see a self-reinforcing move to higher yields.
• With the economy still looking vulnerable...
  In time, this process would normally self-correct, as yields reach levels investors think may damage future growth, prompting a shift of capital back into government bonds. However, with only a nascent recovery and the Fed keen to manage mortgage rates, the stakes are now higher than during a normal ‘convexity hedging’ cycle. The Fed may be unwilling to allow investors to grope towards a tactical peak in yields, because of the damage this would do to already-weak lending growth in the real economy.
• ...the spotlight will swing back to the Fed's, and other central banks',policy.
  The public sector’s bail-out of the private sector transferred, rather than reduced, risk, and government bond yields have now risen to a level where they are casting a shadow on the green shoots of recovery. As yields tend to overshoot to a level where they could materially dampen future growth, the focus is now likely to switch back to the QE policies of the Fed and other central banks. For all the increased optimism of recent months, this recovery still needs to be stage-managed.

Indices, Interest rates and Inflation

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