Why did so many market pundits fail to foresee the decline in yields across the developed world in 2014?

The short answer is they were obsessed with the potential impact of the US Fed’s retreat from unconventional measures while neglecting the importance of global imbalances. In effect, the world has been prey to a growing problem of deficient demand, leading to disinflation, while the US has been growing too sedately to spark the inflationary pressures that would have called for much tighter monetary policy. There is a risk that forecasters will make the same mistake in 2015.

Consider the world’s excess savers, starting with Japan. There Abenomics is having difficulty addressing deflation and raising economic growth. Weak demand resulting from adverse demographics and the recent consumption tax increase means the country is dependent on more bond buying and further yen devaluation to generate the cost-push pressure that would enable the Bank of Japan to meet its 2pc inflation target. China is going through an awkward transition whereby its high rate of investment is beginning to decline. Domestic demand growth has flagged, contributing to the fall in global commodity and energy prices. It also faces a more competitive export environment as others engage in competitive devaluations.

The eurozone is being driven towards deflation by a moralistic drive for austerity that does nothing to arrest rising debt as a percentage of GDP because the harder hit economies have shrunk. Disagreement on the governing council of the European Central Bank ensures a crabwise progression towards full-scale government bond buying without which its inflation target will not be met.

From a different perspective, Richard Batley of Lombard Street Research argues global deflationary pressure has also increased as a result of the relative decline in US economic power. For much of the postwar period the US acted as a clearing house for global demand and supply by maintaining markets that absorbed the rest of the world’s goods. But its supply clearing capacity ran out after 2008 because it had exhausted its debt capacity. Instead of excess supply being cleared through ever higher US household debt, it is now being cleared through lower prices.

All the high saving economies run current account surpluses that require equivalent capital outflows. As their currencies weaken, capital in these countries confronts low yields at home - spectacularly so in the case of Japan and the eurozone - and higher US Treasury yields, along with further potential dollar strengthening. This provides much of the explanation for last year’s decline in Treasury yields despite the maturing of the economic recovery, which would normally have prompted rising yields.

The combination of dollar strength and declining Treasury yields seems likely to persist. Elsewhere in the developed world yields are set to rise, chiefly where default risk enters the picture, as in Greece on the basis of recent political instability. Markets are proving sanguine about other peripheral eurozone sovereign debt. Given the structural flaws in the monetary union, the ECB’s dilatory approach to QE and German-led fiscal conservatism, that may not last. More generally, against the background of a rise in non-financial debt in advanced economies from 212pc of GDP in 1999 to 279pc in 2014, of which more than half has taken place since the global financial crisis, occasional neurotic spasms in the markets are inevitable.

Emerging markets will have a much tougher time in this deflationary world. They may again become an important locus of global financial instability, and not just in Russia. US dollar denominated non-financial debt outside the US stands at more than $9tn, says the Bank for International Settlements, compared with $6tn at the start of 2010. The biggest increase has been in corporate bonds issued by emerging market companies tapping investors desperate for yield. The currency mismatch means a strengthening dollar tightens financial conditions as attempts to pay down dollar debt forces the dollar higher, causing a vicious circle. This is a fearful world in which geopolitical risk, competitive devaluations and protectionist pressure could bring a descent into intractable deflation and long-depressed yields in the absence of robust policy.

The writer is an FT columnist

Published in Dawn, Economic & Business, January 12th, 2015

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