Returns on bonds have been edging higher recently with the yield on the US 10-year treasury note reaching just above four per cent, the first time it has breached this level since the start of the year. Investors have been moving out of treasuries as they start to feel more comfortable channelling funds to more risky assets, such as stocks and corporate debt.
Treasury yields fell 3.29 per cent in March due to the flight to quality and heavy demand at the height of the credit crisis when Bear Stearns was rescued. Market players believe that treasuries are now overvalued.
Yields on 10-year notes could hit 4.25 per cent in the next few months with the yield on the two-year Treasury, currently at 2.75 per cent, could reach three per cent. Investors are starting to focus more on inflation than on an economic slowdown. Higher bond yields are usually associated with times of rising pricing pressures.
The yield on the 10-year note, among maturities more sensitive to inflation, climbed 33 basis points in May, approximately the same increase registered in April, and touching 4.14 per cent.
The two-year note's yield was up by 39 basis points in May and 106 basis points for the past two months, the biggest increase since March and April of 1994. The Federal Reserve was then in the process of raising the target lending rate to six per cent in 1995 from six per cent at the start of 1994.
Demand for inflation-protected debt increased in May as oil prices surged. The difference between yields on 10-year Treasury Inflation Protected Securities (TIPS) and nominal notes widened to 2.51 percentage points, from 2.28 percentage points at the end of April. The spread reflects the annual inflation rate that traders expect for the next decade.
Citibank's world government bond yield, a composite, hit its highest level last week since October.
Euro zone government yields also reached heights last seen in July. Inflation, or the fear of it, is the main driver behind the sell off because it makes holding low yield paper less attractive.
The price of oil will probably have the most impact on bond yields in the near term as when the price goes up it is inflationary, and bonds sell off. The Federal Reserve is now more worried about inflation than a severe recession. Accordingly, the market now expects the Federal Reserve to keep its funds rate at two per cent for the next couple of months.
Some even believe the Fed may be forced to raise rates by the end of the year to combat inflation. This would lead to higher long-term bond yields.
There are conflicting forces between inflationary expectations and a real growth slowdown in the US and in other western markets. Headline inflation has risen sharply across the globe. In the United States, April CPI was 3.9 per cent on an annual basis, while PPI was 6.5 per cent. The sharply higher oil other commodity prices and the dollar's depreciation has led to a rise in the price of imported goods.
However, weakness in the housing market is acting as a deflationary measure. Oil can be viewed as a contributor to inflation, but also as a drag on the consumer, which ultimately will slow economic activity and work to dampen inflation. Economists estimate that every 10 cent rise in prices at the pump will shave about $12 to 13 billion from consumer spending.
For the rest of the developed world, inflation is rising at the same time as growth is generally slowing – on balance, it will probably work to delay monetary easing as opposed to leading to additional tightening.
Canada, Japan and the United Kingdom are likely to maintain interest rates; there is a small chance the European Central Bank could tighten. They are also conscious of the fact that the peak of their expansion cycles has passed and do not want to risk overdoing the monetary restraint.
Emerging markets are also facing inflationary problems for various reasons. Inflation remains a concern for most GCC markets.
Many emerging market currencies, including those in the Gulf, are significantly under-valued and this fuels inflation through higher import prices. Food and energy make up a greater portion of consumer spending than they do in developed markets and increases in these sectors are more likely to spill over into the broader economy. Most emerging markets have faster GDP growth. Slowing growth is an automatic check on inflation and will generally succeed in reining in inflation in the developed world; the story is very different in emerging markets.
Investors will be closely watching bond markets over the next week. However, the trend of investors switching from fixed income to equities is likely to continue.