Time running out for the global bond boom

'It is hard to feel comfortable at present with a level of real bond yields which is this far below the historical average'

The last few weeks have seen an important change in sentiment in the bond markets, which have enjoyed an almost unprecedented global rally in the past 15 months. Yields in the US have become choppy around a stable trend, while yields in Germany, Japan and the UK appear to have reversed trend quite significantly. Naturally, many investors are wondering whether this price action represents the ending of the major bull market for bonds (and incidentally equities) which began in autumn 1994. In fact, some believe that the global bond markets may have become overvalued almost to the same extent as they were in late 1993. The correction of this overvaluation, and the collapse in investor confidence which followed, were the main factors behind the painful bear market for financial assets in 1994.

So are the bond markets of the major five (G5) countries now overvalued, as they clearly were two years ago? One way of answering this question is simply to compare nominal bond yields and inflation expectations now and then. The accompanying table does this.

Taking a weighted average of the G5 economies, the nominal bond yield at present is 5.3 per cent compared with 5.1 per cent at the low point at the end of 1993. Perhaps more importantly, the inflation expectations that are built into the bond markets today are considerably lower than those that existed at the most extreme point of the 1993 bull market, so real yields are higher now. The table shows for each country a forward- looking inflation expectation (based on consensus economic forecasts one year ahead), as well as the actual historic inflation rate over the previous 12 months. It also calculates ex ante and ex post real interest rates by subtracting these two inflation measures from the nominal bond yields.

On both measures, the real interest rates currently built into the bond market are around 0.7 per cent above those which existed at the low point for yields in late 1993, suggesting that the markets are less overstretched now than they were then.

Interestingly, the difference in real yields is most marked in Europe and is less marked in both the US and Japan. For example, taking ex ante real yields, the current yield in Germany is as high as 3.9 per cent, while in France and the UK the real yield is even higher at 4.5 per cent. This compares with present real yields of only 2.6 per cent in both the US and Japan. Although there has been some tendency over long periods for European real yields to be above those in the US and Japan, the current gap is exceptionally large, and this should offer some support for the European bond markets going forward (provided that inflation expectations prove broadly justified).

It is clear from a comparison of real yields that the core bond markets are not as overpriced as they were in late 1993. However, there is probably still some overpricing in the market. Very broadly, for the G5 as a bloc, the nominal bond yield is currently at 5.25 per cent, while the inflation expectation is around 2.25 per cent, implying that the real yield is around 3 per cent. These figures for real interest rates and the inflation expectation both appear to be somewhat lower than the long-term sustainable levels.

For inflation, it seems optimistic to assume that the 10-year average inflation rate over the life of a long bond will be only 2.25 per cent for the G5 economies. Inflation has never been below the current rate (1.8 per cent) for any sustained period since the late 1950s. In several countries, central banks have described sub 2 per cent inflation as virtually equivalent to price stability (allowing for some over-statement for the genuine inflation rate in consumer price indices), and no one seems to have any intention of getting inflation on average below a 2 per cent rate.

Furthermore, with inflation so low, large errors on the upside appear far more likely than large errors on the downside (partly because prices become sticky in a downward direction). Finally, the present low rates of inflation have been achieved at a time when the global output gap is negative (to the tune of around 1.2 per cent of GDP). It does not seem sensible to extrapolate a cyclical low point for inflation indefinitely into the future. For all of these reasons, a 2.25 per cent price inflation forecast over a 10-year period would not be a central guess.

Turning to real interest rates, the present real yield of around 3 per cent compares with an average of 4.75 per cent for the G5 economies over the period since 1983. Consequently, real yields are now around 1.5 per cent below their recent historic average, which is equivalent to about one standard deviation below the mean. There have only been two occasions since 1983 on which real yields have dropped by more than one standard deviation from the mean - in 1989/90 and in late 1993. It is hard to feel comfortable at present with a level of real bond yields which is that far below the historical average.

There is no good reason to believe that the sustainable level of real bond yields is lower now than it has been in the recent past. While this is not the place for yet another long analysis of the behaviour of real interest rates, suffice it to say that at least two factors suggest that the trend in real yields should be upwards, not flat or downwards. The first is that government debt ratios still seem to be on an increasing trend, despite the improvement in budget deficits in some parts of the world. (It is the burden of outstanding accumulated debt which should matter for the sustainable real bond yield, not the budget deficit in any given year.)

The second is the continuing high rates of return being earned on equities, the closest competing asset class for bonds. With government debt ratios and equity returns remaining at least as high as they have been on average in the past 12 years, there is no obvious reason why the real bond yield should be lower than the historic average. (A recent research paper in the Bank of England Quarterly Bulletin for February 1996 confirms the importance of these two factors for global real bond yields, with the level of government debt being by far the more important.)

The conclusion therefore is that the present level of real bond yields is probably lower than can be sustained. This, taken together with the relatively low inflation projection which appears to be priced into today's bond yield, leaves the global bond yield appearing to be somewhat stretched on the downside, with an upward correction being likely over the remainder of this year.

This correction may not start immediately - in fact, it could be delayed for several months as the Federal Reserve and the Bundesbank lead short- term interest rates lower around the world. But once the markets begin to anticipate a recovery in world activity in the second half of this year, bond yields may well have trouble maintaining today's low levels. If so, then gilts seem likely to suffer along with the rest - and, in Goldman Sachs' view at least, this could also spell trouble for share prices in Britain.

Nominal and real bond yields

US Japan Germany France UK Main five economies

Current 1993/4 Current 1993/4 Current 1993/4 Current 1993/4 Current 1993/4 Current 1993/4

low point low point low point low point low point low point

Nominal bond yield 5.6 5.2 3.0 3.0 6.1 5.5 6.5 5.6 7.6 6.1 5.3 5.1

Inflation expectation 3.0 3.4 0.4 0.8 2.2 2.9 2.0 2.3 3.1 3.7 2.3 2.7

Actual inflation rate 2.5 2.8 -0.3 1.2 1.5 4.2 2.1 2.1 2.9 1.9 1.8 2.3

Ex ante real interest rates* 2.6 1.8 2.6 2.2 3.9 2.6 4.5 3.3 4.5 2.4 3.1 2.4

Ex post real interest rates** 3.1 2.4 3.3 1.7 4.6 1.3 4.4 3.6 4.7 4.2 3.5 2.8

* Nominal bond yield less inflation expectations.

** Nominal bond yield less actual inflation rate.