Bond yields have increased significantly since March. This largely reflects greater confidence about economic growth rather than another inflation scare.
This is behind this week's world wide sell-off, including Thursday night's slump on Wall Street.
US ten year bond rates rose by the biggest amount in three years to finish at 5.13 per cent. The Dow fell almost 199 points. That was after European markets fell.
According to the AMP's head of Strategy, Dr Shane Oliver, the rebound in Australian growth (confirmed this week) means the risk of a pre-election interest rate hike is high. Higher bond yields are a risk for shares.
Fortunately, the rise in bond yields is likely to be limited by the soft US economy and as they are already around fair value. Either way bond returns are likely to remain low.
But he says we shouldn't worry too much.
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Over the last few months bond yields have increased dramatically in most major countries as expectations for economic growth have strengthened.
This has seen the Australian 10 year bond yield pushed up to 6.1%. So far this hasn't been a major problem for share markets and other investments.
However, as the share market corrections that occurred in March and October 2005 and in May last year were preceded by, or associated with, spikes bond yields, there is reason for concern.
What's driving the rise in bond yields?
Australian 10 year bond yields are now at their highest level in two years. However, the back up in bond yields is a global phenomenon with yields increasing noticeably since March in Germany (up by 0.6%) and the US (up by 0.5%) and to a lesser extent in Japan. The rise in global bond yields reflects several factors:
The primary driver has been a sharp improvement in expectations for economic growth.
In March this year there were fears that a US housing slump would plunge the US economy towards or into recession with concerns that this would flow onto the rest of the world.
Since then it has become increasingly apparent that the US housing slump is relatively contained. More importantly, growth in the rest of the world has remained strong.
This has shown up as rising real bond yields even though inflation expectations have remained pretty benign.
The back up in US bond yields is due to an increase in real yields, whereas inflation expectations (measured by subtracting the inflation linked real bond yield from the nominal 10 year bond yield) have actually fallen in contrast to what happened when bond yields rose into mid last year.
In other words, real bond yields have increased as confidence about future growth has improved at the same time that inflation expectations have fallen.
There is an emerging change in investment strategies of surplus countries, such as China, which is potentially less friendly for US bonds. In recent years such countries have been investing the bulk of their increasing foreign exchange reserves in US bonds and this has been helping to keep real bond yields down.
However, two developments suggest that this may be starting to change. Firstly, some Asian countries have been allowing their currencies to rise which has meant less demand for US bonds.
Second, some of those countries are starting to diversify away from just holding US bonds. This is most evident with China announcing the establishment of a specific fund to invest a portion of its foreign exchange reserves and was highlighted by its recent decision to take an equity position in the private equity group Blackstone.
Investors may be starting to become more risk tolerant on the back of the bull market in shares and this may result in less investor demand for bonds.
Similarly, as the rise in equity markets has improved the funding position for defined benefit pension funds in the US and Europe this may be resulting in less demand for bonds.
Interest rates and Australian bond yields:
The back up in US bond yields has of course flowed through to Australian yields.
In addition, while recent benign inflation readings are serving to keep the Reserve Bank at bay on interest rates for the time being, the continuing run of strong economic readings, culminating in very strong March quarter GDP growth suggest that the odds of an interest rate hike before the Federal election are high.
GDP has expanded at an average rate of 1.3% over the last two quarters or an average annualised rate of 5.4%. This is well above potential and is evident in very strong retail sales, record car sales, robust business investment, surging profits and a 32 year low in unemployment.
The danger is that this will flow through into a renewed pick-up in inflation which the Reserve Bank will most likely want to head off.
So far the back up in Australian bond yields reflects higher real yields which is consistent with recent benign inflation readings. Inflation expectations as implied by the difference between nominal and real bond yields are pretty stable.
What is the risk for share markets?
Higher bond yields can be bad news for shares because they improve the attractiveness of bonds relative to shares, they increase the cost of capital of business and may lead to slower economic growth.
As can be seen in the chart below, the corrections that started in March 2005, October 2005, May last year and February this year in Australian (and US shares – not shown) have been preceded by, or associated with, higher US bond yields. (Our research has found that US bond yields are more important for Australian shares than Australian bond yields.)
So far the rise in the bond yield has been relatively modest and more importantly it has been driven by higher growth expectations as opposed to an inflation scare. As such, it is far less threatening for sha
