Last week, this column spoke of the inflation genie being out of the bottle and that this explained a large portion of the reaction of the US treasury bonds in recent weeks. That was incorrect. The yields offered by US treasurys went up without inflation expectations going up considerably, except in discussions in the media. The bond market has not become nervous over inflation yet. I am not saying that the genie is still in the bottle. I am only clarifying that the bond market does not think that the genie is out of the bottle yet.
This clarification is based on the behaviour of the yield on US treasurys and on inflation-indexed US treasurys. The difference in the two yields is the proxy for the bond market’s inflation expectations. This gap has barely moved in the last several weeks. The difference in yield between the five-year US treasury note and the inflation-indexed five-year US treasury note actually declined in the last two months! At the 10-year maturity level, there was no movement. The bond market is rather relaxed over inflation. If so, what caused the rise in the yield (or, decline in price) of the nominal US treasury notes and bonds?
One is that financial markets have abruptly reversed expectations of rate cuts in the US. Expectations of the inter-bank offered rate on 90-day dollar deposits in December 2007 have gone up by over 40 basis points. That is a partial explanation. However, the yield on the US 10-year treasury note has gone up by 55 basis points. So, in the jargon, the yield curve has steepened. Put simply, some investors are busy selling the 10-year US treasurys for reasons other than inflation and central bank tightening fears. We have a conundrum on our hands again!
In recent years, treasurys have been bought mostly by central banks. This is because of their need to invest the rapidly rising foreign exchange reserves in liquid instruments. Various studies have concluded that their aggressive purchase of US treasurys helped to hold long rates down in spite of a steady and large increase in US short-term interest rates since mid-2004. Therefore, now that the 10-year interest rate has climbed more than suggested by revision in expectations of monetary policy, we turn to their behaviour for explanation.
One independent research house points to the fact that in May, most Asian currencies appreciated ranging from 1-3%. In other words, periods of Asian currency appreciation, according to them, have coincided with rises in US treasury yields in the last three years. It is because Asian central banks buy fewer treasurys when they do not have to intervene in the currency market. The problem with this explanation is that the 50% of the yield increase took place in the first fortnight of June when Asian currencies weakened! We are still waiting for that cute ex-post explanation for this. So, I offer the first one.
Given that the talk of sanctions, trade penalties and the threat of being named a currency manipulator by the US treasury department loomed large over China, the Chinese government decided to show the US that they too have a strong hand. They either dump some of their treasury holdings or stay away from buying. The yield rises and the price drops. This sell-off reached a feverish pitch on Tuesday last week and that was the day when the US government decided not to name China a currency manipulator. After that, in spite of mixed inflation data, treasury yields declined 15 basis points in the next three days! So, this round of boxing is over.
Regardless of games China and the US play, economic growth and inflation trends point to the upside. That makes it likely that the bond market would stay volatile with more upside risk for yield than downside. Further, one long-time market participant pointed out to me that early in 2004, there was a big inflation scare in China. China’s inflation rate went up from 0.3% in June 2003 to nearly 5.0% in June 2004. During this period, China’s Shanghai A-share index declined by around 30-40%. Morgan Stanley Asia-ex Japan index lost about 15% of its value in this period.
With China’s inflation rising again now—it has gone up from 1.0% in March 2006 to 3.4% in May 2007—a repeat of the early 2004 market correction might be around the corner. China might have to ratchet up tightening measures to arrest the rising inflation trend. Whether they bite bullet now or wait until the Olympics Games are over in 2008, for fear of setting off a chain reaction that they cannot control, is unknown.
Of course, the reaction of the broader financial markets to the turbulence in the US bond market suggests that market participants could not care less. It surely does feel like a strange world. Whether it is a brave new world or a brain-dead world is yet to be determined.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org