What is happening in the Bond Market?
Across the developed markets, long bond yields are moving lower. Lower long yields typically represent lower expectations of NGDP. After all, if NGDP is expected to grow robustly, then either it will cause inflation and bonds will get killed, or it there will be high productivity growth, and stocks will likely do better.
Lower NGDP expectations must mean tighter policy in the short term. At least in my world view that is more or less the definition of tighter policy. Thus, when I see long bond yields move lower, I immediately ask, “who is tightening policy?”.
The answer seems to be everyone. China’s central bank is hard to read, but it appears happy to accept some level of slowdown to put a lid on rampant credit growth. The US is tapering, and good economic data out of Japan is causing people to rethink their expectations of the BOJ easing further. Finally, no one really thinks that the ECB will have the political will to do the kind of Japan level QE that the EZ desperately needs.
Now, despite all that, I don’t think that that is the primary driver of what is happening. I think that falling inflation in the short term (less than 2 years), has resulted in a passive tightening of policy, and that is what is crushing long yields. The real short term rate is the nominal bank rate (in the UK 0.5%) less inflation (annual change GDP deflator). The following graph therefore gives a sense of the “real” short term rate in the US.
So its pretty clear that the low inflation in the US has caused policy to tighten by almost a full percentage point since 2012. If you were to make an adjustment to this for the taper the effective tightening would be even greater. Sadly, I could not make the usually excellent Fred give me up to date series for the EZ GDP deflator – for some reason it ends in mid 2013. I strongly suspect the EZ is in an even worse position.
I think financial markets are waking up to the fact that low inflation might be here for a while, and that this has significant implications on where the “real” policy rate lies, even if there is no change in the expected path of the nominal rates. Remember, policy is expansionary *if and only if* the (real) natural short term interest rate is above the inflation adjusted Fed funds rate. Might we just have seen these cross over? If so, expect the US slowdown to continue, and Europe to go back over the cliff.