Is The Bond Market Signaling A Shift In Central Bank Policy?



  • The bond market is catching a lot of attention early in this new year as it may be signaling that central banks throughout the world at changing direction.
  • Last fall, central banks around the world started reversing the direction of their policies to reflect improving economic growth and financial soundness.
  • Now the world may be entering a new era where central bank policies, uniformly, are moving to return markets to “more normal” operations and interest rate levels.
  • This reverses almost everything.

Right now, the bond market seems to be facing some actions and re-actions that did not seem to be in the playbook four weeks ago.

The biggest surprise to investors appears to be what central banks are signaling and how this might impact international cash flows and, hence, bond yields.

On July 12, 2017, the Bank of Canada raised its overnight rate by 25 basis points, the first increase in the central bank’s policy rate in almost seven years. On September 6, the bank followed up on this increase with a second bump, which brought the overnight rate up to one percent.

On November 2, 2017, the Bank of England raised its benchmark rate by 25 basis points to 0.50 percent, the first move by the central bank in a decade.

The was a lot of talk surrounding the European Central Bank in the last couple of months in 2017 about the possibility that the ECB might begin to cut back on its purchases of securities. A decision was made, and in January, the bank began its new strategy by halving its monthly purchases to €30 billion every month.

Furthermore, on Tuesday, the Bank of Japan indicated that it was reducing its purchases of longer-term bonds. It appeared as if the BOJ was following in the footsteps of the ECB.

Adding to this, there is increasing talk that China would slow down or stop its purchases of US government debt. Some analysts suggested that the announcement of this possibility was a part of China’s political response to the looming US protectionist efforts discussed by US president Donald Trump and his administration. Other analysts cited the review Chinese officials are making about China’s foreign exchange holdings and are suggesting that the country slowdown or halt accumulating more US Treasury securities given the huge role these bonds play in China’s overall portfolio of international debt.

The overwhelming conclusion that one can draw from these movements is that the world may be facing a major shift in central bank policies. For the past eight or nine years, most of the major central banks in the world seemed to be engaged, at one time or another, in rounds of quantitative easing in order to prevent a major economic crisis evolving into a horrendous collapse of the global banking and financial world.

Now, with economies throughout the world producing positive rates of economic growth, with employment conditions relatively calm in most areas, and with banking and financial institutions solvent and relatively stable, the major central banks are moving to the next phase of their monetary policy positions… one that is attempting to achieve a “more normal” level of interest rates where the central banks can return to a more traditional way of operating.

The implication of this move is that interest rates will rise further in Europe and Japan and other areas in the world. It is hard to believe that in late September 2016, the yield on the 10-year German bund was a negative 10 basis points and the yield on the Japanese 10-year bond was also around that level.

In the first half of December 2017, the yield on the 10-year German bund was around a positive 30 basis points as a result of improving economic growth in Germany, while the yield on the Japanese 10-year bond was around a positive 5 basis points, also due to the rebounding economy.

On Wednesday, the yield on the 10-year German bund was just under 50 basis points, while the yield on the Japanese 10-year bond was up to 10 basis points.

All of this movement could be the signal that the “times have changed.”

Exacerbating this whole move in the United States could be the Trump tax bill that was just passed in December. To have the $1.5 trillion in government debt coming onto the scene in an economic recovery that is over eight and one-half years old, with the labor market right around full employment, and debt levels already at historical highs, may be an exercise in “inappropriate timing.”

Is there any concern in the financial markets about this situation?

I believe that there is, and that concern is being exhibited in foreign exchange markets.

The euro is trading very close to $1.2100, the highest level in over three years. The British pound is trading very close to $1.3600, the highest level in over one and one-half years. And, the dollar has dropped significantly against the Japanese yen over the past three months.

And, as far as the Federal Reserve is concerned, there will be almost a totally new Board of Governors at the Fed this year. It is a known unknown about how they will act given these totally new circumstances, circumstances coming from an environment that has never been experienced before. What happens to the bond market – and why – is still something that must be observed?

Whether they want to or not, the Governors at the Federal Reserve may have to pay a lot more attention to what is happening internationally this year and to what is happening to the value of the US dollar. This may take attention away from the recently passed tax bill, something the Republicans wanted to tout in this year’s midterm elections. However, it appears to me that these events might dominate what the policymakers have to deal with.