What are the consequences of rising bond yields?

by Shaun Richards
So far in 2018 we have seen a move towards higher bond yields across the financial world. This poses more than a few questions not least for the central banks who went to unparalleled efforts in terms of scale to try to reduce them. This as I pointed out on the 6th of December led to some changes.

The credit crunch era has brought bond markets towards the centre stage of economics and finance. Before then there were rare expressions of interest in either a crisis or if the media wanted to film a response to an economic data release. You see equities trade rarely but bonds a lot so they filmed us instead and claimed we were equities trades so sorry for my part in any deception!

At the moment they are back in the news and this morning the Bank of Japan responded. From the Wall Street Journal.

The Bank of Japan took on the market and won—for now.
As Japanese 10-year bond yields threatened to break through the 0.1% mark early Friday, the bank threw down the gantlet and offered to buy out every player in the market.

If we step back for a moment it is hard not to have a wry smile at the Bank of Japan defending a yield on a mere 0.1%!  Not much of a yield or a bear market is it? It poses the question of how strong the economic recovery might be if that is all we can take. Overall it is a consequence of this.

“Today’s action was aimed at firmly implementing the bank’s policy target of guiding the 10-year yield around zero, taking into consideration recent large increases in long-term yields,” a senior BOJ official said. For the BOJ, “around zero” essentially means up to but not including 0.1%.

I am not so sure about the “large increases in long-term yields” story as in fact the thirty and forty-year yields have been dropping. But the response was as follows.

The bank offered to buy an unlimited amount of JGBs with remaining maturities of five to 10 years at a fixed rate of 0.11%, the same level it used on two previous occasions. Yields slipped to 0.85% from 0.95%.

This poses a couple of questions. Firstly for the argument that the Bank of Japan is tapering its bond buying or QE ( which is called QQE in Japan) as offering to buy an “unlimited amount” is hardly tapering. The issue here you may note is rather like that of the Swiss National Bank defending the Swiss Franc at 1.20 which suddenly found it was intervening on an enormous scale. So what looks like tapering could morph into expansion quite easily. How very Japanese!
Also I guess if you own 40% or so of a market as the Bank of Japan does you too would be touchy and nervous about any rise in yield and fall in prices. Time for En Vogue on its tannoy loudspeakers.

Hold me tight and don’t let go
Don’t let go
You have the right to lose control
Don’t let go

Maybe our songstresses even had a view for us on how likely it is that the central banking control freaks will reverse course.

I know you think that if we move too soon it would all end

The UK
This is an intriguing one as you see the ten-year Gilt yield has risen to 1.58% this morning  Here is how Bloomberg reflects on this.

Ten-year gilt yields climbed five basis points to 1.58 percent as of 9:29 a.m. London time, after touching 1.59 percent, their highest level since May 2016. The yield has surged about 40 basis points this year.

This is considered a bear market which as someone who has definitely seen such moves in a day and maybe when we were ejected from the ERM in 1992 maybe an hour is hard to take. So let us settle on a QE era bear market. Also the QE link comes back in as the high for UK Gilts was driven by the panic buys of late summer 2016 when the Bank of England dove into the market like a kamikaze pushing the yield down to 0.5%. From time to time apologists for such moves claim that QE does not make losses but if you pay 120 for something and get back 100 at maturity what is that please?
Intriguingly at least one player may have been wondering about a real bear market. From James Mackintosh in the WSJ.

The trade goes like this: borrow £750 million ($1 billion) for 100 years at a time when money is basically free. Invest it in shares. Pocket the difference.

Okay perhaps not a real bear market as that would affect shares too and as you see below the money is cheap in historical terms but not free.

 The scale of that demand was shown Wednesday when Wellcome’s 100-year bond was more than four times oversubscribed with a coupon of just 2.517%, the lowest ever paid on a corporate century bond.

That is not likely to be much in real yield terms and I would much rather be Welcome that those who bought the bonds. They think along the lines I pointed out in my post on Monday on pensions and the distorted world there.

Wellcome Chief Investment Officer Nick Moakes says ultralong bonds are distorted by rules forcing insurance companies and pension funds to buy them at any price, creating an uneconomic demand he is happy to satisfy with a bond issue

Of course buying equities at what is something of a top after a succession of all-time highs might be a case of not the best timing.
The US
This is the leader of the pack on such matters on two counts. It is the world’s largest economy and it currently has a central bank which is in the process of raising interest-rates. It’s central bank is even reducing its stock of bonds albeit at a snail’s pace. If we stick with the domestic impact then it is led by the thirty-year yield which has nudged over 3%. This means that the thirty-year fixed mortgage rate is now 4.23% as we look for the clearest link between the financial world and the real economy.
If we look at the shorter end of the scale we see that the rate rises so far combined with the expectations of more have seen the two-year yield rise to 2.16% as opposed to the 1.2% of this time last year. So there has been a tightening of monetary conditions all round from this route.
There is a lot to consider here and let us start with the economics. A rise in bond yields tightens monetary conditions and in that sense is a logical response to the better economic environment. However it is awkward for central banks who have paid more than the 100 they will get from their treasury on maturity as politicians have got used to spending the explicit and implicit profits. If they sell their holdings then they will exacerbate the price falls and weaken their remaining stock.
Moving to the foreign exchanges we have seen something rather odd. If you buy the US Dollar you get 2.8% right now if you put the money in a ten-year US Treasury Note whereas if you buy the Japanese Yen you only get 0.9%. So the US Dollar is rising right? Eh no, as I have covered many times. Of course some may be buying now thinking that an US Dollar in the 109s is attractive combined with picking up a 2.7% relative yield. Similar arguments can be made for the Euro and UK Pound £ albeit with smaller yield differentials.
Here is another thought for you. Imagine a Swiss or German version of Wellcome if there is one and how cheaply they could borrow for 100 years. Actually with its international position it could presumably have borrowed in Euros. Perhaps it is bullish of the UK Pound £……..brave if you look back 100 years.
Meanwhile if the bond bear market and its consequences are all too much there is apparently something which can take the pain away.

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