Eye on the Bond Market

Many of us (see for example Brad DeLong) have been wondering for some time why the bond market does not seem to be reflecting expectations of a dollar depreciation into its prices. Shouldn’t investors be demanding higher interest rates to compensate them for the exchange rate risk that they’re taking on by holding dollars? Yet bond yields have stayed surprisingly low.

One possible explanation is that the signals that the bond market is sending have been somewhat distorted this year (i.e. not reflective of average market sentiment) because of the large-scale participation of foreign central banks in the bond market. The chart below shows the 6-month moving average of net purchases of US treasuries by foreign central banks and governments.

It’s plausible to imagine that the $15 or $20 bn in net monthly demand for bonds this year by foreign official institutions could be affecting prices. Since central banks (and other government actors) often pursue different objectives from the typical private investor, bond prices may therefore not really have been reflecting market expectations.

However, there’s some evidence that foreign central banks are curbing their appetite for US government bonds. If this is the start of trend, then bond prices may increasingly reflect market expectations.

In the last couple of weeks long-term bond yields have risen by a quarter of a percentage point. But more interesting is what has happened to the inflation expectations that the bond market reflects. In the last two months the bond market has revised upward its inflation expectations for the coming five years considerably…

Is the bond market simply predicting higher future growth, and thus inflationary pressures, over the next five years? Or is this the first sign that some bond market players are pricing in a future dollar depreciation? (Note that a dollar depreciation will cause a jump in US inflation as imports become more expensive.)

I don’t know the answer, though the latter seems more likely to me than the former. But I do know one thing: keep your eyes on the bond market.


UPDATE: The inflation expectations presented in the chart above reflect the difference between the 5 year Treasury note and the 5 year TIPS. My apologies for not making that clear.