US treasury yields to remain anchored

American treasury yields are likely to remain “anchored” even if the scale of additional quantitative easing (QE) disappoints, Capital Economics predicts.

The London-based macroeconomic research consultancy published its latest Capital Markets Analyst report yesterday evening, ahead of the Federal Reserve’s plans for a second wave of QE.

Capital Economics is sceptical the rally in American equity markets will last much longer given the outlook for earnings. Emerging equity markets, on the other hand, are likely to outperform.

However, pumping more money into the economy may improve the overall outlook for the economy. This is likely to benefit the dollar but not so much for many of the commodities.

Capital Economics, like many other analysts, predicts the Fed will feed another $500 billion (£309 billion) into the economy.

More QE would mean more assets purchases by the other major central banks, which would then increase the quantity of reserves held by commercial banks. (article continues below)

In theory, this means that commercial banks can lend more. However, it does not mean they will.

So far the QE that America has seen has done little to bank lending and economic activity. This is starting to improve but QE is likely to only have a direct impact on bank lending if it succeeds in lowering the expected cost of borrowing enough to stimulate demand.

Capital Economics says this is “far from guaranteed in economies saddled with debt”.

Yet QE may still have a positive effect on the American economy as it is likely to support asset prices through portfolio rebalancing. Investors, Capital Economic says, have sold government bonds to central banks have reinvested the proceeds elsewhere.

“We can only think, however, that there is a point at which investors’ faith in policymakers’ ability to resolve the crisis will start to waver if a second round of QE fails to make much of a difference to economic activity or to prevent the onset of deflation,” the report says.

Capital Economics expects the 10-year nominal yields not only in America but also in Britain and Germany to remain near current lows for some time to come. Since spring, yields have been declining driven by a reassessment of the outlook for interest rates and more recently the expectation of further purchases of government bonds by central banks.

Although some temporary upward pressure on bond yields is likely in case the scale of additional QE were to disappoint, Capital Economics says it doubts this effect would last.

American interest rates are likely to remain on hold for some time to come and risk appetite is increasing, while deflation is still more of a threat than inflation.

“Even if yields did rise, central banks could always buy more bonds,” Capital Economics says. “It is not out of the question that additional QE could also push up yields if it were much larger than expected. The determining factor in this case would be whether such a policy choice significantly raised expectations for growth and inflation.”