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Capital Economics: eurozone crisis wil flare up again this year -

Here's some analysis from Julian Jessop of Capital Economics on today's minutes from the Federal Reserve Open Market Committee meeting last month. Among other points, he predicts more alarm in the eurozone this year.The revelation (although hardly new) in the latest FOMC minutes that some members would favour at least a tapering of QE by the end of the year has refocused attention on the role that Fed buying has been playing in keeping Treasury yields low. (See US section below.)The conventional wisdom appears to be that 10-year Treasury yields are only likely to remain below 2% if the US central bank maintains its current pace of buying. In fact, the launches of successive bouts of quantitative easing have seen yields rise, rather than fall. Instead, the prospects for Treasuries depend mainly on the outlooks for short-term interest rates, inflation expectations, safe haven demand and other overseas buying, which together should keep yields low for at least another year.At first sight, it might seem obvious that the Fed’s purchases of government bonds under QE3 have been a key factor keeping their yields low, and hence that any scaling back of these purchases would inevitably see yields surge. But the reality is more complicated. Indeed, Treasury yields actually rose during most of the period when the Fed was buying government bonds during QE1 and QE2, and are higher now than when the Fed launched QE3.There are several ways in which large-scale central bank purchases of government bonds can put upward pressure on their yields. One is by raising long-term expectations for inflation. Another is by improving the prospects for the real economy and increasing the appetite for risk, thus encouraging investors to buy assets such as equities or industrial commodities rather than safe-haven government bonds. (Correspondingly, these riskier assets might be the major casualties if the Fed stops buying Treasuries, rather than Treasuries themselves.) To the extent that QE succeeds in restoring confidence, it might lead investors to revise up their expectations for the average level of short-term interest rates over the life of the bond too. The upshot is that we would not necessarily expect a sustained rise in Treasury yields even if the Fed, perhaps mindful of the implications for its balance sheet and eventual exit strategy, does scale back its purchases later in the year. These concerns may matter less for “conventional” monetary policy and high unemployment would still be likely to keep official interest rates on hold near zero. There is also now more room for inflation expectations to drop again, especially if commodity prices continue to fall.Finally, other investors might simply step up to take the Fed’s place. In particular, we expect a renewed escalation of the euro-zone crisis in the second half of the year to boost safe haven demand for Treasuries. And at the margin, the fact that the Bank of Japan will now be buying a lot more JGBs may encourage (or even force) some Japanese institutions to increase their purchases of Treasuries instead.