Wednesday, May 7th, 2014

Don’t Wait for an Explanation

There has been a rash of press articles commenting on the extent to which bond yields in the G7 have fallen since the turn of the year. This wasn’t supposed to happen. According to the consensus, bond yields were going to rise as economic growth accelerated and the Fed and other central banks tightened monetary policy. Even allowing for the ability of financial markets to over-discount future developments, this goes down as a significant forecast error – one which could have implications well into Q3.

We make no claim to have forecast the fall in yields, but we did see the situation developing in all of the asset allocation models we run, sterling, euros and dollars. It was also clear that this was not driven by equity weakness or volatility. First equities have not really been weak, even if they have been disappointing; second bond yields did not react to equity strength (on the few occasions it happened). We often find that we identify trends before we or the forecasting community can fully explain them. We are never concerned by this because we think the numbers are more important than the narrative. But at a psychological level it is nice to be able to explain something ex post, even if we can’t forecast it ex ante.

Over the last two weeks the explanation has been provided with a suitable fanfare of publicity. In Europe, the EU Commission cut its forecast for inflation from 1.0% to 0.8% for 2014 and from 1.5% to 1.2% for 2015. This is the second time in six months that it has reduced its forecast and further reductions cannot be ruled out. Economists of a monetarist persuasion claim to have forecast this all along – somebody always does. Our point is that you don’t need to understand the minutiae of M3 aggregates to observe the same trend driving government bond yields right across the Eurozone.

The performance of UK index-linked gilts provided further evidence that inflation forecasts were too high. They have been outperforming conventional gilts since late February, but it is only recently that investors have extrapolated the strength of sterling into downward pressure on CPI. It is not easy to fit a conventional monetarist explanation to the UK data, and it is quite clear that the UK economy is at a different stage of the cycle than the Eurozone. Nonetheless we see the same inflation / bond yield dynamic.

In the US the story is about slower growth not falling inflation. Q1 GDP figures came in at 0.1% annualised against a consensus forecast of 1.2% and a Q4 comparator of 2.6%. Even though some of the gap will probably be revised away in coming weeks, we get the sense that many investors are in denial about the scale of the miss. Equity bulls are still happy to stick with their forecast of a second half recovery. A lifetime of investing has taught us never to underestimate the US consumer, but we won’t believe these forecasts until we see a decisive break in the trend of falling bond yields.

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