|  DEC 1992

Bond Yield Diagnosis by John Kean

Bond Yield Diagnosis by John Kean Inflation is usually the first choice for analyzing the forces driving the direction of bond yields, but systems analyst John Kean illustrates that charting government borrowing can help determine the trend of interest rates. Bond yields are one financial factor that stands out from the rest in importance. They are a critical item in economic growth, have a particularly strong influence on stock prices and foreign exchange rates and are often used as a metaphor for a country's overall economic and political health. Although bond yields are acknowledged to be important, they are also considered to be hard to explain and even harder to predict. Breaking bond yields down into component parts can help us understand them. Of the factors often mentioned in connection with bond yields, three of the most substantial should be examined in detail: inflation, economic activity and government borrowing. INFLATION, ECONOMICS, BORROWING Inflation is most often cited in connection with long-term interest rates. Superficially, this makes good sense. In reality, however, the last 80 years have seen prolonged and sharp departures between U.S. bond yields and inflation rates, and in the last few years, the U.S. has been in one of the more pronounced divergences. As Figure 1 shows, inflation has offered only limited explanation, much less prediction, for bond rates over the last 24 years. Number-crunching reveals that highest-grade U.S. bond real yields (that is, yield minus inflation) averaged only 0.81% from 1914 through 1982 and 1.05% from l950 through 1982. During the 1980s, average real Treasury bond yields expanded to 5.5% from 1983 on, a huge increase. Clearly, culprits other than inflation are at work in determining bond rates.

by John Kean