The rise in longer-term bond yields in recent months is judged here to reflect a combination of improving investor expectations for second-half economic performance and growing scepticism of the ability of central banks to suppress yields below their “equilibrium” level. The alternative explanation that the increase has been driven by a shift in Federal Reserve policy is implausible – the economic implications of the Fed “tapering” in September rather than December are trivial.
With their ability to control longer-term rates in doubt, central bankers have turned to “forward guidance” to try to anchor the short end of yield curves. Last week’s dovish policy statements from the ECB and Bank of England were an attempt to reverse a May / June rise in market expectations of interest rates over the next two years – see chart*. This effort has been only partially successful – expectations have unwound about half of their earlier rise.
So is forward guidance, like QE, losing traction? The problem is partly that ECB / BoE guidance is “weak form”, stating that the central banks expect, on the basis of their current economic forecasts, to maintain low rates for longer than implied by the market. Such statements, however, have little value given the central banks’ proven inability to forecast.
Markets, therefore, may push shorter-term yields higher again in an effort to secure a Fed-style commitment to maintain current rates even if growth / inflation significantly exceed current projections. Such a commitment, however, is likely to be a step too far for the Bundesbank and its allies, and several – possibly a majority of – UK MPC members.
The central bankers have made exaggerated claims about their ability to manipulate yield curves to deliver further monetary stimulus. They are in danger of being exposed as emperors without clothes.
*Overnight indexed swap (OIS) rates incorporate market expectations of the average level of overnight interest rates over the term of the swap.
