What goes up might come down.

Photographer: Carl Court/Getty Images

Solving the $450 Billion Bond Rout Mystery

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
Read More.
a | A

Here's a radical explanation for the rout that's wiped more than $450 billion off the value of bonds around the world in the past few weeks. Maybe it's the economy, stupid.

Yes, I know: Fundamentals are so last decade. Central bank meddling is supposed to have rendered bonds useless as an economic barometer. After the European Central Bank embarked upon quantitative easing in March, prices rose and yields fell (even turning negative) across Europe. With a central bank committed to buying 60 billion euros of securities every month, people began wondering whether any other outcomes were even possible.

The Fed Eases Off

But they should have considered this: The Federal Reserve seems hell-bent on raising interest rates this year. Whether you agree with the U.S. policy makers or not (and there are plenty who don't), they're signaling that the world's biggest economy has turned the corner. And your bond market textbook tells you that an improved growth outlook will eventually stoke inflation, so you need higher yields on your fixed-income investments to compensate -- and the only way that happens is for prices to fall.

Moreover, it turns out that reports of the death of the euro region economy may have been somewhat exaggerated. Just two months ago, the gap between 10-year borrowing costs in Germany and the U.S. was at its widest in a quarter of a century, reflecting the expectations economists had for a sustained economic rebound in the U.S. combined with no growth and a risk of deflation in the euro zone.

Figures released on Wednesday, though, showed that the euro economy grew by 0.4 percent in the first quarter -- twice the pace achieved by the U.S. That in turn reflects months of euro economic data beating expectations while U.S. figures have been more of a disappointment:

Again, the bond market textbook says if the ECB is overseeing a healthier rebound than the Fed, it stands to reason that German yields should rise even more quickly than those for U.S. Treasuries -- and that's exactly what's happened.

The so-called bond rout, though, also raises the problem of context. The following chart, showing the recent price action in the German bund futures contract, looks really ugly. This is the type of market you'd hope your pension plan hasn't gone anywhere near:

But the sell-off/correction/whatever-it-is looks a lot less damaging when you consider the journey that the bond market has undertaken on a longer timescale:

So after all the handwringing and heartache over what happened with bonds in recent weeks, two conclusions emerge. First, higher yields are a sign that chunks of the global economy are on a glide path to recovery. And second, 10-year German borrowing costs at their current level of 0.7 percent are a lot less worrying than the 0.05 percent low they reached in the middle of April. Maybe -- just maybe -- the euro region has dodged the deflation bullet.  

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net