James Bevan: Prospects for global bond markets
0
In the 1980s and 1990s, it was held by many that what was bad for Japanese government bonds (JGBs) would ultimately prove to be bad for all bond markets.
This was predicated on the observation that Japan was one of the primary sources of global savings at the time and, accordingly, if the price of “savings” rose in Japan for whatever reason, it was likely to rise elsewhere as well, sometimes by a large amount for countries with low savings such as Australia.
During the 1990s, it was also the case that the Japanese yen / US dollar rate often acted as a useful leading indicator for global inflation trends and particularly for inflation “surprises”.
During this period, Japan had emerged as an important global price setter in many consumer goods markets and fluctuations in the yen tended to affect the traded goods sectors of many countries’ consumer price indices – and most inflation surprises can be traced back to fluctuations in the prices of imported goods (including in early 2007).
Japan’s global impact
With this in mind, looking forward, policy-induced weakness of JGBs and yen strength could prove generally negative for global bond markets.
The relationship between the yen and world trade prices weakened during the mid-2000s global boom that preceded the financial crisis, likely due to Japan’s falling share of global trade. Although, the dollar-yen exchange rate has continued to provide some “lead” on global trade prices.
We might assume that Japan’s loss of market share has benefited China and, to a lesser extent, Korea. Deflation is continuing to be exported by Korea as a result of its high inventories and also its ongoing requirement to produce large trade surpluses.
What’s more, the economic risks for Korea at present relate primarily to weaker credit trends, weaker growth, stronger deflation and downward pressure on the Korean won over the medium term. It, therefore, seems unlikely that Korea will become a source of global inflation in the near term.
It’s much harder to forecast China’s outlook – its weak balance of payments, slowing rate of private sector credit growth, and even the operation of its now aggressive quasi quantitative easing (QE) regime should all bias the renminbi (RMB) towards weakness (which would be deflationary for the world). But, at present, the People’s Bank of China (PBoC) is fighting this pressure with direct intervention.
Also, China’s monetary growth has been booming over the last few months (as a result of the QE) and its people seem already to be attempting to diversify away from simply holding wealth in cash (hence the strength in some sectors of the property markets).
These events tend to be inflationary, at least within the domestic economy. In addition, Chinese companies seem to be intent on closing their huge financial deficits, which may include raising prices where possible.
Indeed, in renminbi terms, China’s rate of GDP inflation has already started to edge higher along with the produce price index and the corporate goods price index.
Perhaps more importantly, the rate of China’s GDP deflation in dollars has slowed somewhat over the last six months and the country’s rate of export price deflation has stabilized in US dollar terms. China does continue to export deflation in an absolute sense – but there is a possibility that the latest fiscal easing/QE could result in inflation if the PBoC continues to defend the RMB.
Over the longer term, we should expect the renminbi, Korean won and the Japanese yen to each decline with deflationary consequences for the world and we see deflation as a key risk for the global economy.
But, in the short term (i.e. over the next few months), the various trends within the North Asian economies probably argue for there first being a shift up in inflation that could well lead to unwelcome inflation surprises in developed markets.
Thus, we could have yen appreciation on the back of disappointment in the Bank of Japan, and China pursuing its present policies, leading to positive inflation surprises within the global economy. This could then drive disquiet within bond markets.
Treasuries
Japanese government bond yields were remarkably stable in the late 1980s with 10-year bonds trading quite tightly between 4.5% and 5.0%, and this was a good period for most asset markets. But in October 1989 they broke higher as Governor Mieno moved to curtail the bubble economy.
US Treasury yields also started to move higher a month later in 1989. Thereafter, once the bubble economy burst, Japanese bond yields started to fall in July 1991, followed a month later by Treasuries.
JGB yields then started to move higher again in January 1994, although this was several months after Treasury yields had started to rise, with significant divergence between the two economies at that time.
Treasury yields then peaked in November 1994 and moved lower until mid-2003 but each of these turning points occurred approximately a month after their equivalents in Japan. The relationship isn’t tight, but on balance there does seem to have been some truth in the notion that JGB yields tended to lead Treasury yields in the US and elsewhere in the Post Plaza Accord (1985) era.
One thing that has changed between then and now is the relative size of Japan’s current account balance and hence its supply of (net) savings to the world economy.
Thus Japan’s current account balance as a percentage of global GDP is small today relative to overall global savings, as it was during the early 1980s.
Japan won’t, therefore, be a big supplier of savings to the world and this should imply that JGBs won’t have a big impact on (real) bond yields around the world, particularly within the context of a world that seems to be moving towards systemic savings surpluses.
That said, Japan may be the first major central bank to end QE and if the Bank of Japan’s forthcoming review process does cast official doubt on the wisdom and efficacy of QE, it may become big news for bond markets.
Indeed, with government indebtedness still rising faster than nominal GDP in much of the developed world, and global inflation rates arguably about to rise, if only temporarily, we may expect that it wouldn’t take much in the way of policy uncertainty to rattle bond investors who can at this point only be holding ultra-low or negatively yielding government bonds because they expect to make holding gains when central banks buy more of them.
Over recent years, this has, of course, not been an unreasonable expectation given the size of the various countries’ QEs in relation to their issuance of public sector debt securities. However, if the BoJ casts doubt on QE, markets may begin to fear that the anti-QE sentiment will spread.
Bears and booms
For the medium to long term, we can suspect that China’s boom will end in domestic inflation and a (much) weaker renminbi. We can also be bears of the Japanese yen over some “unspecified” period (i.e. not yet).
This demise of the North Asian model would likely prove deflationary in its early stages for the global economy.
But on balance and for the near term, we suspect that the inaction of the Bank of Japan and rising nervousness in debt markets may nevertheless deliver a rise in nominal bond yields over the remainder of the year.
James Bevan
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
Photo (cropped) Japanexpertna.se, Flickr.
