BOND YIELDS : EVEN LOWER FOR EVEN LONGER / THE WALL STREET JOURNAL

Heard on the Street

Bond Yields: Even Lower for Even Longer

Central-Bank Policy, Geopolitics and Lackluster Economies Keep Rates Low

By Richard Barley

Aug. 28, 2014 12:54 p.m. ET
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The U.S. Federal Reserve has steadily cut back bond purchases. Bloomberg

It has been a one-way street in global bond markets this year: Yields just keep on falling.

There seems to be little in the cards to reverse this trend. But investors should still think carefully before embracing it.

German 10-year yields stand at just 0.88% and have fallen more than a percentage point this year; two-year yields are negative. That is at least understandable: Euro-zone growth and inflation are at worryingly low levels.

But elsewhere, falling yields are questioning some of the market's basic assumptions about the relationship between economic data and bond prices. In the U.S., where second-quarter growth ran at a 4.2% annualized pace and the Federal Reserve has steadily cut back its bond purchases, the 10-year Treasury yield has fallen to 2.32%, down about 0.7 percentage point this year. And in the U.K., where growth has boomed and two of the Bank of England's monetary-policy makers have started voting for an increase, 10-year gilts yield 2.36%, down from just over 3%.

There are several factors at work. Investors might normally expect the vast and liquid U.S. Treasury market to set the tone for global yields. But Europe appears to be in the driver's seat for two reasons. The first is speculation that the European Central Bank will be forced into adopting quantitative easing, providing a further flood of liquidity. The second is that investors appear focused on relative rather than absolute value. 

Thus a decline in German yields makes U.S. bonds look cheap; U.S. yields get dragged lower. This could go further: Royal Bank of Scotland thinks 10-year German bund yields could hit 0.65%.

Meanwhile, geopolitical risk is running high. The Middle East is in turmoil. The crisis in Ukraine has deepened rather than receded. That leads to both a flight into haven bonds as well as concerns about spillover effects on Europe in the case of Ukraine.

Even with a recovery under way, conditions are subdued relative to history. In the past four quarters, nominal gross-domestic-product growth in all of the Group of Seven leading economies bar Japan has been below the average since 1990, Barclays notes; this is largely due to a decline in inflation.

The global financial crisis also has shrunk the pool of securities that are regarded as free of credit risk. But the appetite of investors for safety hasn't diminished.

With few apparent catalysts for a reversal, investors shouldn't rush for the exit. Indeed, recent flows show investors buying both European and U.S. government bonds, Citigroup notes, with an acceleration in purchases of Treasurys in particular in the past month.

But with yields already so low, embracing the rally could be dangerous, too. Markets appear overconfident in the ability and willingness of central banks to heal all economic ills; arguably central banks themselves are worryingly assured on this front. 

The chance that inflation accelerates appears underpriced. It looks risky to buy in earnest now.