In our view, world markets

today are also in the grips

of the central banks, with
no other factor wielding so
much inuence.
The Lords of Finance
Rise Again: Central
Bank Signals and the
Outlook for Bond Yields
By Paul Brain
Investment Leader for Fixed Income
Newton
EXECUTIVE SUMMARY
Paul Brain, Newtons investment leader for xed income, looks at
bond investors hyperfocus on central bank signals in anticipation
of a potential tapering of the Feds asset purchases. Paul discusses
the main factors that might drive bond yields higher over the next
months as well as what could prevent them from drifting too high
as we enter the nal quarter of the year.
The Lords of Finance are back in control again. In his award-winning book, Lords
of Finance: The Bankers Who Broke The World, Liaquat Ahamed describes the period
following the First World War, when the four most powerful men in nance were the
central bankers of the U.S., U.K., France and Germany. In our view, world markets
today are also in the grips of the central banks, with no other factor wielding so
much inuence: as central banks set the price of money and control the ow of
funds, we see that investors have little choice but to play along.
What happens when these Lords of Finance decide enough intervention is enough?
We had a taste of that when, in May, the U.S. Federal Reserve outlined the reasons
for reducing its inuence on nancial markets through reduced purchases of bonds,
which could possibly begin in the fourth quarter.
Following the First World War, as detailed by Ahamed, the Lords were united in their
fear of ination, and their common vision was to turn back the clock and return the
world to the gold standard. Their legacy was the Great Depression and ultimately a
period of high ination and, some may argue, agstones in the groundwork for the
Second World War.
THIS TIME IS DIFFERENT!
Since the Feds announcement of May 22 we have witnessed much speculation
about the tapering of its quantitative easing program (QE), and the likelihood that it
will raise bond yields and be negative for risk assets. As a result, an adjustment
phase has been experienced in all nancial assets that have been buoyed by
speculation over continued QE. We suggest this has created some anomalies.
THE LORDS OF FI NANCE
RI SE AGAI N // 2
We think that the market
will continue to anticipate
less bond-buying by the Fed,
particularly as employment
data continues to improve,
causing Treasuries to remain
under pressure.
For instance, if we take the Fed at their word on maintaining ultra-low interest rates,
why should the short end of the U.S. yield curve have priced in a rate rise? Short-
dated bond yields have risen by as much as those at the longer end, despite being
anchored by a zero interest rate policy. Suggesting, perhaps, that the markets had
misinterpreted the Feds previous guidance, the Fed Chairman pointed out the error
of their ways and stated that monetary policy would remain accommodative for a
while yet. The other anomaly is that bond markets around the world have fallen (yields
have risen), either in line with, or in some cases by more than, U.S. bonds. If anything,
the economic statistics from these other economies have been weaker, led in part by
concerns over Chinese growth.
So, apart from a rise in bond yields, what has changed over the last few weeks? The
Fed maintains that any reduction in the pace of Q.E. is dependent on data: recently,
we have observed that G10 economic growth is recovering gradually, but Asia and
China seem to be slowing. The concern about China, in addition to the strength of
the U.S. dollar, is weighing on commodity prices. Furthermore, longer-term concerns
about emerging markets appear to have escalated: it is of little surprise, then, that
emerging-market debt has been one of the worst-performing asset classes over the
last few months.
U.S. bond yields have reached levels at which they are strongly inuencing mortgage
rates, but the momentum in the U.S. housing market suggests to us that yields may
have to rise even higher before they turn the market.
In January, we identied a yield of 2.5% for the 10-year Treasury as a point where
the market should pause. From here, we think that yields are likely to drift higher if
employment gures continue to improve, or until we see clear evidence that higher
yields are having a negative effect on the economy.
How far could yields rise in this environment? Or rather, how far will they be allowed
to rise? The absence of sharp increases in the federal funds rate means we are not in
the same situation as in 1994; the Federal Reserve raised rates by 3% between February
1994 and February 1995, the U.S. 10-year yield went from 5.84% to 7.93%, and ination
expectations rose sharply. We think 10-year U.S. yields are likely to stay in the 2.5% to
3.0% range in the near term. We expect that the market will be inuenced by a number
of opposing forces over the summer before being able to rally later in the year.
The following is a list of what we think will be pushing and pulling yields. First, the
reasons why U.S. Treasury yields may gradually rise during the rest of the summer:
In our view, the asset class is very over-owned, and is therefore vulnerable to
fund outows. Much of this could already be reected in the price as, in light of
recent market events, many funds may now be more defensively positioned and may
have anticipated further fund ows. But we observe that there is usually a delay
between initial price moves and ows, and we anticipate less buying activity by
funds, and possibly a bit more selling.
We think that the market will continue to anticipate less bond-buying by the Fed,
particularly as employment data continues to improve, causing Treasuries to remain
under pressure.
We expect that the volume of emerging-market central bank buying of U.S. Treasuries
may be anticipated to be lower in the future. In particular, if the Chinese decide that
they too need a weak currency, we think there would be less need for them to recycle
their current account surplus into dollar assets.
THE LORDS OF FI NANCE
RI SE AGAI N // 3
The age of the Lords of
Finance is with us again.
The membership of the
group has changed a little,
but the need to keep a lid
on borrowing costs in the
face of high debt burdens
suggests to us that we
are stuck with this form of
inuence for some time yet.
We think there may be lower safe-haven demand from investors concerned
about a eurozone crisis, who may be lulled into a false sense of security ahead
of the German federal election on September 22.
Finally, while perhaps not really a negative for Treasuries but certainly not a
support as yet, we assert that it may take a bigger rise in mortgage rates to
take the froth out of the housing market.
On the other hand, as we head towards the fourth quarter and as yields are higher,
we nd there are a number of factors that could prevent yields rising too high:
Ination is lower, so real (i.e., ination-adjusted) yields will be increasingly
attractive. Investors may, we believe, prefer the certainty of positive bond
real yields to the vulnerability of equity income.
Although U.S. growth may be stabilizing, there are signs (including data from
the International Monetary Fund) that suggest that other areas may be slowing
fast. Eventually, we think this will inuence the U.S. economy.
The Chinese economy in particular seems to us to be slowing, albeit that support
from the authorities could lead to less money being available for authorities to
spend on U.S. Treasuries. The eurozone could still be vulnerable, but we think it
is unlikely to wobble too precariously before the German election later this year.
The Federal Reserve will still be buying U.S. Treasuries even if they begin the
process of reducingtheir rate of purchases.
The broader U.S. economy is still, according to recent ISM data, not very robust.
On balance, in the absence of a signicant shock, we would expect yields to rise steadily
in line with improvement in the U.S. employment market. Accordingly, if employment
gains zzle out, we think yields would stop rising. The fragility of U.S. and global growth
will, we believe, limit the rise in yields from here. We think the current debt-burdened
global economy would struggle to cope with new government funding (in the U.S. at
least) at a rate above 3%.
This leads us back to the Lords of Finance. We think they wont allow rates to rise
too much because the world simply cant afford it. The Japanese central bank was
disappointed by the markets reaction to their intervention policies in April and managed
to convince investors to push Japanese government bond yields back down (prices up).
Both the Bank of England and the European Central Bank have reminded the ckle
bond market that monetary policy is unlikely to change for a very long time. Finally,
the Fed has also felt the need to remind the market about how accommodative
monetary policy is. One could also add the Chinese authorities to this list of market
manipulators, following their attempts to ddle with interbank rates in recent weeks.
1

The age of the Lords of Finance is with us again. The membership of the group has
changed a little, but the need to keep a lid on borrowing costs in the face of high debt
burdens suggests to us that we are stuck with this form of inuence for some time yet.
1 When Liquidity Meets Control in China, Financial Times, June 18, 2013.
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