Rising bond yields: a cause for concern?
Across the world the cost of government borrowing is rising. The yield (or interest rate) on a 10-year UK government bond (the debt issued by the UK government) has risen from around 1.6% a month ago to 2.0% today.
In Germany the move has been even more dramatic - from around 0.05% to 0.7%. These sorts of moves are being seen in the US, Japan, Australia, Thailand, India and just about any other country one chooses to name.
The yield on bonds moves inversely to the price (so has the price increases the interest rate falls and vice versa). In other words, the price action of recent days has been a sharp fall in the price of government bonds. This could have huge implications for the price of other financial assets, for the interest rates faced by firms and households and, potentially, a negative impact on the real economy.
The bond market, especially the market for highly-rated, safe government debt is often regarded as sleepy place.
In contrast to the high octane worlds of share and currency trading, it's a market which (it is usually assumed) takes a longer-term and more considered view. The kinds of moves that have taken place over the last few weeks - and picked up pace today - are highly unusual.
All things being equal, sovereign bond prices should be counter-cyclical, they should move in the opposite direction to the wider economy. In theory, when the economy is weak and expected to remain weak then the market will assume that short-term interest rates are set to remain low or be cut.
That is good for bond prices which will remain high or rise, pushing down the yield. If the economy is strengthening, then the markets should assume that short term interest rates are likely to rise, that would push the price of bonds down and the yield up. Investors would start to switch out of bonds and into assets that perform better in a growing economy - such as stocks or commodities.
Is the 'bond bubble' over?
But that all relies on "all things being equal" and they rarely are. So, while a gradual rise in bond yields (and fall in prices) could usually be taken as sign that an economic recovery is being entrenched, the pace of the move in recent days suggests that this benign scenario may not play out.
Two factors are sitting behind the move. First, by almost any conventional metric, sovereign bonds across much of the world (and especially in the eurozone) look to be seriously overvalued. There's been talk of a "bond bubble" and, if there is one, it seems to be in the early stages of popping.
A month ago, when the German 10-year bond yielded only 0.05% (and the price of the bond was high) then anyone buying those bonds was either betting that the economic prospects for Europe were so abysmal that interest rates would be held low for a decade or, and perhaps more likely, they thought they would be able to find someone else to sell the bonds to in the future for an even higher price. They might be overpaying but hoped they could find someone else who would overpay by even more.
This overvaluation has left bonds vulnerable to a sell-off.
Second, for months there have been worrying signs that liquidity in the bond markets has been drying up. It has become harder and harder to buy or sell bonds without moving the price.
This is due partially to tightened financial regulation, which has made the big banks less happy to hold large portfolios of bonds and act as "market makers" (buying and selling to provide liquidity) and partially as the supply of safe government bonds has fallen as government deficits have come down across the developed world and central banks (through quantitative easing) have bought up bonds and effectively taken them out of the market.
In recent moves, this lack of liquidity has helped explain some of the scale of the price rises - in an illiquid market a relatively small pick-up in buyers can push prices higher. Today that lack of liquidity is contributing to the large falls.
Overvaluation and the lack of liquidity are the ultimate drivers of today's moves. The swing factor prompting the sell-off is still being debated but one likely candidate is a change in the market's expectations of inflation.
Go back a few months and the view that the West faced a period of very low inflation - or even outright deflation (falling prices) - was near consensus. In that environment, interest rates would remain low and bond prices high.
Academic rates discussion?
But with the price of oil spiking since January and measures of inflation in the UK, US and the eurozone looking to be turning a corner and showing signs of picking up, that view is becoming less common.
It may be that the market calms down in the coming hours and days. A gradual rise in yields as inflation picked up and growth became more entrenched (especially in the eurozone) would be something to welcome.
But the fear is that yields had become lower than the actual fundamental state of the global economy warranted. They may now swing the other way.
Back in December, several newspapers made a big deal of UK mortgage rates hitting historic lows. If the yield on UK government debt spikes higher, that will not last for long. Borrowing costs across the economy will rise.
For much of the last year there has been an earnest discussion on when the Bank of England or the Federal Reserve will start to raise rates, but this could soon become academic. Whatever the level of short-term rates, the market-determined (and more important) level of longer term borrowing costs could rise.
Managing the process of returning interest rates from record low to more "normal" levels was always going to be a challenging task for central banks. If the price moves of the last few days continue then it may be taken out of their hands.