Surprise plunge in bond yield forecasts may spell more trouble ahead

June 22, 2012

By Rahul Karunakar

The spread between 2- and 10-year U.S. Treasury yields will shrink to 180 basis points in a year according to the latest Reuters bonds poll – the narrowest margin since August 2008, the month before Lehman Brothers collapsed.

Historically, that spread has been a key indication of what investors and traders are thinking about the economy’s prospects: the narrower it gets, certainly with short-term rates already at rock bottom, the darker the outlook.

It wasn’t looking particularly good in August 2008, and of course we all know what happened the following month: the start of an epic financial and economic crisis the world is still struggling to shake off.

A narrowing spread, driven by long-dated yields falling, might be welcomed by central banks who are aiming to bring them down to stimulate growth. But it’s also a dark sign for what people broadly feel is going to happen in the economy.

Said John Silvia, chief economist at Wells Fargo:

“I don’t think it is good news. It just tells you that the overall expectation for growth in the U.S. is weaker over time.”

A prolonged period of no or low growth, negligible inflation and near-zero interest rates has raised the spectre of a Japan-style ‘lost decade’. While most analysts don’t think the U.S. is in such a state, half the respondents in a Reuters poll last month said expected that to be the euro zone’s fate.

That poll predicted the 10-year German/Japan yield spread at 100 basis points in a year, the lowest expectation since the series began in 2002. That was slashed again this month to another low of 90 basis points.

Bond strategists this month have collectively slashed their forecasts for major countries’ bond yields across every single time horizon polled for the first time since Reuters began polling on yields a decade ago.

While that sentiment itself is not surprising, having the consensus drop so aggressively is striking given that major government bond yields are already at historic lows as a result of unprecedented money printing and near zero rates.

Part of it is also the inflation backdrop.

Plunging oil prices and a retreat in inflation pressures – even in Britain where they have remained relentlessly strong – also explains the sharp cut in 10-year yield forecasts.

Another is ballooning central bank balance sheets and (so far) rampant expectations they’ll still get a lot bigger.

While the Federal Reserve extended its “Operation Twist” programme at its June meeting, which is aimed at knocking down long-term yields, primary dealers polled by Reuters after the decision put the chances of more money printing at 50-50.

Wells Fargo’s Silvia again:

“At some point in time though this has to end.”

While analysts still expect bond yields to eventually rise, that won’t happen anywhere near as quickly as thought just a few months ago. That could quite possibly be very bad news.

 

 

Analysis by Ashrith Doddi

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