"Front end" bond markets sanguine about rate rises, or complacent ?"

Friday 24th July 2015

 

 "Front end" bond markets sanguine about rate rises, or complacent ?"

"Complacency on policy forecasts put bonds out of kilter with rate reality", Michael Mackenzie, The Financial Times, p.30

Traditionally, the short (or front) end of bond markets is the area that really feels the pain when a central bank embarks on a course of rate rises. This is logical enough .... in terms of time to maturity alone, 2yr note has much more in common with what a central bank charges for overnight money than a 10 or 30yr bond. Besides, a great number of factors go in to pricing up the longer end. If for example a rise in the Fed Funds rate was seen as a prudent move towards combatting inflation concerns (which longer bond markets hate), in the right circumstances the move could actually be read as a positive one. Not so with the front end.

So , with the Fed seemingly guaranteed to raise rates by the end of the year (September is now the favoured date amongst most pundits), why have prices remained so high and therefore yields so low in the 2yr Treasury Note ? Currently it yields around 0.7% with Fed Funds at 0.25% and has returned below 1% since 2010.  The same situation applies in the UK incidentally, arguably even more so. The 2yr Gilt yields 0.64% with the Bank of England's overnight rate at 0.5%, and this at a time when B of E governor Mark Carney is making increasingly frequent hints towards a rate rise.

Back to the US, and the answer must be that the markets believe Fed Chairwoman Janet Yellen when she stresses that the upward path of interest rates will be very gradual in nature. By extension, this means that they (like she) believe that continued upward US growth and inflation numbers are not guaranteed, and that there are considerable headwinds still to be negotiated  --  think Greece, China, emerging markets etc. And then there's the effect of higher rates on the currency.....

Across the globe developed nations are embarked on a programme of rate cutting, or at least keeping rates low. Against such a background, the US (and the UK) embarking a rate rising cycle brings with it the obvious likelihood of a stronger (you might say even stronger) currency. This  dampens exports and therefore growth, and through cheaper imports helps to cap inflation. In effect, a stronger currency acts as a form of monetary tightening in itself and contributes to relieving the pressure to raise rates.

So the relative strength of the front end looks justified ..... well, maybe. For every view there's a counter-view. Its very strength indicates that it has not to any degree priced in the possibility of the unexpected occurring in the way it has in the past. In this instance we're talking about higher-than-forecast growth and inflation prompting an accelerated course of rate rises. Looked at in this light, the front end looks vulnerable, or at least unprepared. And if we know one thing, it's that the unexpected can and does happen.