Can We Still Trust Bond Yields Amidst QE?

Despite unprecedented QE by central banks around the world the bond market remains a valuable gauge of risk appetite.

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We have a question from Steve who asks whether bond yields are still an accurate measure of overall risk appetite since bond yields are manipulated buy the massive amounts of QE.

Thanks for the great question Steve, and it’s a very valid question amidst this unprecedented amount of quantitative easing we’ve seen from the Federal Reserve.

Now as you know, government bonds, especially your high rated bonds like US treasury notes, bill and bonds are considered as one of the safest investments money can buy, and the reason for that is because there is a very low likelihood that the US will default on its debts.

Also, we know that one of the biggest drivers of bond prices and by extension their yields, is short-term and long-term interest rates. Whenever the market thinks turbulence is ahead, the expectations for interest rates to fall will increase, and when that happens, bond prices will rise as demand for bonds increase, which of course pushes their yields lower.

The opposite is also true, so when expectations for interest rates to go up start rising, we usually see bond prices fall as demand for bonds as a safe-haven diminishes as investors seek higher yield in more risky assets like equities or higher risk bonds in emerging markets for example, and when the demand for bonds fall and their prices fall we see bond yields rise.
So, generally speaking, lower bonds yields are usually a good sign for lower risk appetite or risk off and higher bond yields usually a good sign for higher risk appetite or risk on.

Now the challenge that Steve is pointing to comes in with QE, as a central bank like the Federal Reserve will artificially keep interest rates at the back end of the curve lower by buying bonds with higher maturities at an unprecedented scale.

So, the front-end of the curve is kept low by keeping the Fed Funds Rate low and the longer-end of the curve is kept lower by QE. Now, if that is the case, and yields are artificially kept lower, are bonds still useful as a gauge for risk sentiment.

And I would say they definitely are. Even with US 10-year yields at record low levels, yields can always go lower. If things turn out bad enough and the economy takes another turn for the worse, then yields can go much lower from here, even go into negative territory if things get bad enough, as the worse things get the more the Fed will buy and the more portfolios will move into bonds as a safe-haven.

Now on this there is inflation to keep in mind, in that, if inflation starts to rise drastically you might see outflows from bonds into things like TIPS or gold as a hedge against inflation, especially if you are buying bonds at such low yields.

So, to your question, QE has definitely kept yields low and will keep them low for a while still, and even though that might mean they can move a bit disconnected here and there, the bond market will always remain a good barometer for overall risk appetite, sometimes seeing the warning signs long before equities does, and will remain a very handy warning sign whenever we see bond yields fall while equities remain elevated.

So, hope that helps Steve, any other questions please don’t hesitate to let us know.
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