Here is the full report from JP Morgan:
The first round of August figures on the U.S. economy showed no relent in the downward growth trend of recent months: both the National Association of Homebuilders’ survey of housing market activity and the Philadelphia Fed manufacturing activity index disappointed analyst forecasts and fell short of last month’s levels, while initial unemployment claims also worsened, rising for a third consecutive week and taking the 4-week average up to its highest level since December 2009. Equity markets ended the week slightly lower and are in moderately negative territory for the year, but the persistent decline in government bond yields – both in the U.S. and other developed markets – remains the more alarming development, calling the comparative resilience of equities and commodities into question. But even though we expect the economic recovery to remain subpar, and possibly slow further under the combined weight of private and public sector deleveraging, there are a number of reasons why the slump in yields does not in itself cause us undue concern.
First, it is not entirely unusual to see bond yields continue to fall even after a recession has technically ended. Following the 1969/70, 1990/91 and 2001 recessions, 10-year Treasury yields kept falling at least a year into the recovery, taking fully 2.5 years to reach their lows after the early ‘90s downturn. What made the difference in these cases was the direction of Federal Reserve interest rate policy. In each episode, the Fed continued to cut rates even as the economy was recovering, with longer-term rates only starting to rise once policy easing had ended. And while the Fed’s recent decision to re-invest the proceeds of its maturing mortgage-backed securities into government bonds does not strictly constitute easing now, rate hike expectations have fallen back significantly over the past year and the chances of another round of quantitative easing in the balance of the year are high. To assess the message that intermediate- and longer-term yields might be giving, short term rates must therefore also be taken into account. 10-year Treasury yields may be near historically low levels, but short term rates are at historic lows and the yield curve slope is thus more consistent with recovery than recession – this is true whether one looks at 10-year yields relative to policy rates or indeed (to control for the unusually low level of policy rates) 30-year yields relative to 10-year yields (see chart).
Second, much of the rise in U.S. household saving over recent quarters has been used to purchase government debt securities. As of the end of Q1 2010, U.S. household Treasury holdings had soared by 46.2% over the prior year; indeed at $795.7 billion, households were the second largest holders of Treasuries (excluding their indirect holdings via pension and mutual funds), ahead of Japan, ahead of the Fed, and only $100 billion behind China. Furthermore, as last week’s senior loan officer surveys revealed, household demand for credit continued to decline in the second quarter. The rise in the household saving rate has clearly held back the growth rate of consumption over the last two years, but to the extent that it stabilizes near current levels (which should be the case in the absence of a another downleg in house prices and/or stock markets), the higher level of the saving rate should allow consumers to continue to pay down debt and start to rebuild wealth without cutting back on spending. In this regard, the downward pressure on bond yields from increased household saving could be viewed as a positive.Related articles:
But perhaps most important with regards to the fall in yields is that inflationary expectations (both breakeven inflation rates and survey-based measures) are still well above their lows of late 2008, and far away from signaling expected price deflation on the part of either investors or consumers. So long as the U.S. avoids a potentially self-fulfilling anticipation of falling prices (which would erode business profit margins and potentially force a new round of employment cutbacks), the likelihood of a double-dip should remain low. However, the risk of deflation will only increase the longer that growth remains below trend. With Congress seemingly reluctant to approve much more in the way of fiscal support measures, the onus will likely remain on the Fed to further increase the size of its balance sheet (which would more than likely push bond yields down even more) if the economic weakness persists.
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