THE CASE OF THE INCREDIBLE SHRINKING BOND YIELDS / THE WALL STREET JOURNAL

Heard on the Street

The Case of the Incredible Shrinking Bond Yields

By Richard Barley

May 30, 2014 5:23 a.m. ET

The world is facing a new bond-market conundrum. The decline in global bond yields, which has confounded investors betting on 2013's rise continuing, has accelerated even in the face of rallying stocks and reasonably bright economic data. That looks dangerous.

President of the European Central Bank Mario Draghi speaks during a news conference in Frankfurt, Germany. Associated Press

Ten-year U.S. Treasury yields Thursday hit 2.4%, a level not seen for nearly a year, before rebounding slightly higher. U.K. gilt yields have fallen nearly half a percentage point to 2.56%, and German Bund yields at 1.32% are within sight of all-time lows. If Dutch 10-year yields fall a little more than 0.1 percentage point from current levels, they will be at their lowest since records started in 1517, Deutsche Bank DBK. notes.

Myriad forces have driven this rally. Banks are being forced to hold more government bonds as liquidity buffers. Pension funds have been switching into bonds after last year's steep rally in stocks. Central banks are striving to sound dovish—even those that are having to think about starting to tighten monetary policy, with both the Federal Reserve and the Bank of England arguing that rate rises will be gradual and that rates will top out lower than they have in the past. Global inflationary pressures appear low. 

And perhaps most powerfully, institutional investors made exactly the wrong bet at the start of the year on the direction of yields and have been scrambling to reverse it. Since they probably suffered losses in January's rally, they may be reluctant to place new trades betting on rising yields.

From a fundamental point of view, the decline in German yields is perhaps the most understandable. Euro-zone inflation is running at just 0.7%, growth has proved disappointing and the European Central Bank is almost certain to ease policy next week. The decline in German yields has helped spur demand for higher-yielding government bonds elsewhere.

But much more puzzling is the behavior of the U.K. bond market. It is clear that the BOE will be the first leading central bank to raise rates, its dovish tone notwithstanding. The U.K. economy is performing strongly, racking up real growth in the first quarter of 3.1% and nominal growth of 4.4% compared to the prior year. The latter is often a proxy for long-term bond yields, yet 10-year yields are almost two percentage points lower than that. There is not even the excuse of particularly low inflation: it stands at 1.8%, just below the BOE's 2% target.

Bonds appear largely immune to news of better growth. But there are three big risks to this rally. The first is that the ECB may disappoint markets next week: a rate cut, including a negative deposit rate, and some measures to ease credit flows look more than fully priced-in. The second is that central banks like the Fed and the BOE, concerned by the way markets are behaving, start to sound more hawkish.

The third, and potentially most important, is that markets may be wrongly convinced of the persistence of low inflation. If price pressures start to build, then bond markets could reverse course violently.