The Hindu Business Line : Bond yields set to rise

You need to be extraordinarily smart and savvy (or lucky) to make money in bond markets these days. For, they have defied the understanding of legends such as Alan Greenspan, the previous Chairman of the US Federal Reserve. Stocks, of course, barely noticed his famous 1996 utterance of "irrational exuberance".

The Dow and NASDAQ continued their more or less straight rise to peaks — close to 12,000 for Dow and 5,000 for NASDAQ. While the Dow has now surpassed its 2,000 high, the NASDAQ is still just about half its all-time top, reflecting the waning of the fortunes of the tech sector (barring the likes of Google and eBay). That the behaviour of share prices often eludes explanation is widely-known.

Yield curve

But what about bonds? Here was the Fed on a rate-raising spree - 17 increases in as many meetings - and there were bonds acting as if nothing had happened - in fact, their prices starting moving up significantly in the most intense phase of the Fed's tightening.

Soon enough, the yield curve inverted with yields all along the one to 10-year segment of the curve falling below the Fed Funds rate. The farther one went, the lower are yields - ten years are less than five years which are less than two years.

So what happened to the risk premium - the extra return investors want to hold long-dated paper? Do they think the Fed has got inflation by the scruff of the neck? Or is a recession around the corner and the yield curve will be beaten into its normal shape by early rate cuts?

Reserves

A third plausible reason offered is that developing country reserves, particularly those of China, are flowing into Treasuries without regard to yield or the Fed rate cycle. Mr Ben Bernanke even speaks of a "global savings glut" which has no home other than US Government bonds.

The inverted yield curve phenomenon is not confined to the US. Short rates are higher than long in the UK while the euro yield curve has noticeably flattened in the last few months with talk of a curve inversion occurring in the near future.

Sustainability

Is it a sustainable market condition? Paradoxically, the global economy has never performed better, with the IMF predicting another stellar year. And inflation is clearly creating a flutter among central banks. Bonds have rarely been more expensive in relation to domestic and global economic conditions.

A big thumbs down for inflation and a huge positive for growth is the recent sharp fall in oil and commodity prices. Time then for fundamentals to assert themselves and yields to rise sharply?

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