The Big Picture: World Central Banks Temporarily Soothe The Market But Worry Long-Term Investors

(October 2012) Tom Kenny of recently published the “ 2012 Third Quarter Bond Market Returns: the Third Quarter in Review”.  In the report, he highlights the fact that emerging market bonds had a stellar quarter – up almost  7% , while long-term treasuries where slightly negative-  down less than a quarter percent.
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What could explain this difference? The Fed and the ECB have been heavily involved in the markets. During June, the end of the second quarter, there were questions if the Fed would engage in another round of printing money (formerly known as quantitative easing). Also unknown was if the European version of the Fed, The ECB, would be also engage in supporting the markets. The answer to both questions was yes. The ECB and the FED both starting buying bonds and pushing down yields.

Fed & ECB Buying Should Be Good For All Bonds – Why not long-term Treasury Bonds?

Bond Prices have two components – interest rate risk and credit risk. If interest rates go down, then bond prices go up. If the credit risk or the chance that the bond will not make payments to bondholders goes down, bond prices go up. The credit risk associated with US treasuries is minimal. So really, treasuries are all about current short-term interest rates and future interest rate expectations. Investors compare the extra yield they get for holding longer term bonds versus the chance that they will miss out on higher interest rates later.

What happened with long-term treasuries?

Short-term interest rates on treasury bonds are effectively zero. For holding a two year bond, a bond holder receives only a 0.23% yield. The FED’s most recent actions did not change the interest rates on short-term bonds. On the other hand, the FED’s actions did change the future expectations of inflation. When the FED prints money, the eventual consequence is higher inflation.

What happened with emerging market bonds?


The FED and ECB’s actions have decreased the chance of a global recession. There is less risk of a collapse of the Euro. There is less risk of a stock market collapse. There is less risk that companies will be unable to borrow money. Bottom line, there is less risk of something really bad happening. With this risk diminished, investors are more willing to invest in more risky assets like emerging market debt and corporate bonds.

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