False Hopes from Bonds?

Rising yields don't necessarily mean a rebound is near

From the U.S. to Brazil to Singapore, either growth is anemic or economies are contracting. Unemployment is rising more rapidly in the U.S., Europe, and most of developed Asia than it has in 20 years. Industrial output in Germany is sharply down. And Japan? Let's not even talk about Japan.

This is how a global recession is supposed to feel: nasty, grinding, depressing. But wait a minute. One traditional bellwether is behaving as if a turnaround were just around the corner. Government-bond yields around the world have risen sharply since the first week of November. A bond rally after the Federal Reserve cut rates Dec. 11 did little to dent the jump in yields. Even Japanese yields have moved up a notch. Bond buyers, it seems, are signaling their belief in a U.S. recovery in the first quarter that will be strong enough to pull Europe and perhaps even Asia out of the trough.

STIMULUS PACKAGES. Should officials in Washington and the European capitals take heart and cancel their stimulus packages? Unfortunately, the answer seems to be no. Although some sort of recovery is likely next year, analysts are hard put to find an explanation for the nearly 25% surge in yields. "It's not as if there's convincing evidence that a sustainable recovery is imminent in the U.S., let alone anywhere else," says John Davies, a fixed-income analyst at Westdeutsche Landesbank in London. "Given that, you've got to wonder whether the markets are acting sensibly."

Normally, bond prices fall and yields rise after good economic news. That's because investors reckon they can make more from equities when the economy is expanding. So rising yields on German Bunds, U.S. Treasuries, and British gilts have often been taken as an indicator that a recession will soon be over. Economists point out that they accurately signaled the start of recovery during the recessions of 1981-82 and 1990-91.

But in fact it's difficult to read much into the bond market's behavior this time. For one thing, the markets have responded unpredictably to economic developments. When alarming U.S. employment data were released on Dec. 7, yields in Europe and the U.S. rose rather than fell. Between Nov. 7 and Dec. 11, yields in Continental Europe grew at their fastest clip since 1987, despite a series of gloomy economic developments.

EXUBERANCE. Investors who sold bonds on the assumption that the U.S., spurred by the lowest interest rates in 40 years, is set to rebound, were probably mistaken. As the Federal Reserve pointed out on Dec. 11, when it reduced the federal funds rate to 1.75%: "Weakness in demand shows signs of abating, but those signs are preliminary and tentative." One U.S. bank's bond chief put it more succinctly: "This really is a case of irrational exuberance."

Some of that exuberance may be technical. Many of the speculative investors who made a killing from bonds decided to sell in November and December in case the economy did turn the corner. "We were worried about being caught out by good economic news," says one London fund manager. "So we closed out our positions and locked in our profits." Other investors were unnerved by the collapse of Enron Corp. and the crisis in Argentina and decided it was time to get out of fixed income.

Some contend the markets are moving in reaction to non-economic considerations. Bond-yield rises may be driven by "the extraordinary pace of progress in the U.S. war effort in Afghanistan," says David Gilmore, an economist at Foreign Exchange Analytics, an advisory firm in Essex, Conn. That's not the kind of emotion that can sustain a real change in yields.

In fact, the mood could shift quickly--and yields could come down as swiftly as they have risen. "Once investors catch on to the economy's continuing weakness, they could flock back to bonds," says the U.S. banker. Then, once more, it will be a matter of waiting for that elusive recovery, and a true turn in the global bond markets.

By David Fairlamb in Frankfurt

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