Buttonwood’s notebook | Bond markets

The great bond conundrum

Bond yields are at historic lows. And they keep getting lower

By Buttonwood

AT THE start of 2015, the yield on Germany's 10-year bonds was 0.54%, which probably did not look very enticing to investors. Now, however, the yield is just 0.1% and seems to be heading inexorably for zero. Already the average yield on all German debt is negative. A recent survey found that a net 84% of global fund managers thought bonds were overvalued.

How far can this go? That is the dilemma. In the long run, such a yield looks crazy; in the short run, not so much. The European Central Bank is buying bonds to the tune of €60 billion ($64 billion) a month. Betting against a purchaser with an unlimited credit card is like standing in front of a train. Nor does it matter whether or not you believe the evidence that the euro-area economy is recovering (something that would normally cause bond yields to rise). "In this monetary policy environment, short-term data don't matter" says Salman Ahmed of Lombard Odier, a fund manager.

One can only have mixed feelings about this. In some respects, the argument for lower bond yields is a "this time is different" case familiar to those who lived through the dotcom bubble (and thus deeply suspect). On the other hand, people have been calling the top of the Japanese bond market for more than a decade, without success. Back in September 2011, the British weekly, the Spectator wrote that

The worldwide bond bubble is going to burst

But it has not yet done so. As Justin Fox, a shrewd observer of these things, wrote yesterday, the media overuses the bubble term. But there have been a lot more of them in recent decades (the first chart, from GMO, an investment-fund manager, defines a bubble as a price that moves more than two standard deviations from its real trend) so it is tempting to see them everywhere.

In your blogger's view, this is the result of central-bank policy, which has tended to intervene when asset prices fall, but not when they rise. This "asymmetric ignorance" has encouraged speculation and also landed central banks with a dilemma. If they fail to cut rates, or tighten policy, markets may crash. But with each crisis, the required level of support gets greater, moving eventually from the simple measure of cutting rates to outright asset purchases. At each step, the need to intervene proves overwhelming. As Tim Geithner, former Federal Reserve governor and Treasury secretary, once wrote:

trying to mete out punishment to perpetrators during a genuinely systemic crisis—by letting major firms fail or forcing senior creditors to take haircuts—can pour gasoline on the fire. Old Testament vengeance appeals to the populist fury of the moment, but the truly moral thing to do during a raging financial inferno is to put it out.

The result of all this, however, is that it gets ever more difficult to normalise policy. As a report published earlier this year by McKinsey, a consultancy, showed, total debt levels in most advanced economies are higher than before the crisis. Private-sector debt has simply been shifted onto public balance sheets. Servicing that debt at interest rates of 4% or 5% a year would be too much of a strain. Countries like Sweden that started to tighten policy and raise interest rates have been forced to retrace their steps and cut them again.

So it may be at least a bit different this time. Regardless of whether you believe in secular stagnation, both real and nominal growth are lower than they used to be (see second chart).

That would also suggest that interest rates will be lower than before.

Another difference is that an old taboo has been removed; that of the zero nominal bound. Central banks have cut short-term rates below zero in the euro area, Denmark, Sweden and Switzerland. Bond yields are also negative in many of those countries; the Swiss even issued a 10-year bond with a negative yield. Economists used to think this wasn't possible. After all, investors can hold physical cash as an alternative. But it seems that yields will have to be much more negative before they do that. In part, this is because of the nature of modern money; few people want to hold great piles of cash. It is neither convenient nor secure. Most modern money is electronic and that is subject to negative rates. Furthermore, many investors (pension funds, insurance companies, commercial banks, central banks) are forced, or at least accustomed, to holding government bonds for regulatory or accounting purposes; they are indifferent to price or yield.

There must be some negative yield at which attitudes would change. Mr Ahmed points out that, if yields fell below -2%, it would be worth setting up a hedge fund, converting client money into cash and holding it in a vault, and offering to outperform the bond market.

We are not there yet. So what would bring the bond bull market to an end? A tightening of Federal Reserve policy might not do it, not least because the gap between Treasury and German bond yields is already high. Any surge in Treasury yields would prompt buying by European investors. A return to healthy global growth might not do it either, because of the problem already referred to: a surge in bond yields might end up sabotaging such growth because debt levels are still so high. The trigger for a crash would thus need to be a rise in inflation on such a scale that central banks would be forced to act, regardless of the growth consequences. Some bears think that this will be a two-stage process in which deflation is so severe that the authorities will be forced to target inflation by opening both the fiscal and monetary taps. But times are not quite that desperate yet.

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