The extent of distortion in the bond markets is quite remarkable.
By
Roger Bootle: Two weeks ago, I suggested
that the bond market was caught up in a serious bubble and that its
potential bursting represented the greatest threat to financial stability.
Since then, bond markets here and abroad have indeed been weak. But you
ain’t seen nothin’ yet.
True, this isn’t a bubble in the classic sense of markets holding unrealistic
expectations (as they did, for instance, during the dotcom boom). It arises
as a result of the correct perception of official policy. But the extent of
the distortion this has caused in the bond markets is quite remarkable.
In the 1950s and 1960s, UK government bond (gilt) yields had averaged about
5pc. There had been periods when gilt yields had been much lower, for
instance in the Great Depression of the 1930s. But not as low as now. At the
recent trough, yields dropped as low as 1.5pc. Even after the recent bond
weakness, UK 10-year yields are still only about 2pc.
Index-linked bonds currently present the most remarkable features. For most of
their history, such “linkers” have yielded between 2pc and 4pc after
inflation, that is, in real terms. Recently, however, real yields have been
negative. That’s right, investors have willingly held them at yields which
are bound to lose money in real terms. And investors even have to pay tax on
the interest.
So what is going to happen? What the appropriate level of interest rates and
bond yields should be when things have returned to normal will depend
crucially upon inflation. If inflation is expected to run at something like
2pc, then we can expect conventional long bonds to yield between 4pc and
6pc.
But there is a long road between here and there. It does look as though the UK economy
is starting to recover. Thank goodness. Full recovery here and abroad would
see those higher bond yields realised. Eventually. But for all the reasons I
have rehearsed in these pages before, recovery is likely to be slow and
fitful. This will reduce the attraction of other assets, keep the threat of
relapse and renewed crisis alive and argue for short-term interest rates to
stay at these low levels for an extended period.
Even if recovery takes hold, it will be a long time before the crisis of the public finances is under control. Indeed, the ratio of government debt to GDP will surely continue to rise for several years yet. During this time, it is vital that the cost of financing the deficit (and refinancing maturing debt) is kept low. This argues strongly for continued low short rates.
If the authorities ever resort to a policy of deliberately higher inflation to work down the real value of the debt, it would similarly be vitally important that bond yields stay low. Otherwise, even a burst of unexpected inflation would do little good as the markets quickly priced in higher inflation – and possibly even more inflation than was actually going to occur. The result would be a significant increase in the cost of financing the deficit, the end result of which could be that the debt to GDP ratio hardly came down at all, or even rose.
So the authorities would surely need to maintain very low short rates while simultaneously putting pressure on the banks, pension funds and insurance companies to maintain high ratios of bonds in their portfolios “for safety reasons”. This is exactly what happened in the UK and the US in the years immediately after the Second World War and it is already happening again now.
In other words, such a regime would involve sharply negative real interest rates and real yields. That is a substantial underpinning for the value of all sorts of assets, including residential and commercial property and equities. But, of course, the foundations for such resilience are distinctly dodgy, because eventually the bond bubble will have to burst. For equities and commercial property, the hope is that the recovery in the economy that would by then have taken place would be sufficient to outweigh the influence of higher bond yields. (Residential property would have no such support, unless the rate of increase of average earnings had taken off.)
But even if this were broadly true, the two would not happen smoothly in tandem, so it would be an extremely bumpy ride. And when bond yields rose, this would inflict huge capital losses on their holders, who would be dominated by these same banks, pension funds and insurance companies.
Of course, it is possible that the bond market crisis could occur sooner. The most likely cause of this, in my view, would be a surprisingly strong economic recovery. This is a situation where the first interest rate rise, even though it was only 0.25pc, would have a disproportionate effect as market operators speculated about how soon the next rise might occur.
Any change in interest rate perceptions would be extremely dangerous. Both individuals and the corporate sector would start to fret about the implications. The effects could be particularly serious in the housing market – just as it was entering a recovery phase.
This is why, despite the fact that some commentators are already warning of the need to put up rates soon, I suspect that the incoming Governor of the Bank of England will rather see his task as to ensure that people hold to the view that rates will stay low for an extended period. This will make a strong case for so-called forward guidance, where the central bank explicitly says that it does not expect to raise rates before some specified future date.
The exchange rate will also be a key factor. Last week’s trade figures were encouraging, but there is a long way to go to rebalance the UK economy towards exports and corporate investment. The last thing that we need is renewed sterling strength. Indeed, some good judges think that the pound needs to be even lower. If we soon raised rates here and/or began reversing QE, there would be a serious danger of sparking a sterling rally which would play havoc with our hopes of achieving a rebalanced economy.
If and when the euro crisis flares up again – and I am pretty sure that it will – you will see a flurry of funds pouring into gilts “for safety”. Yet, looked at over the medium term, gilts are just about the most unsafe asset around. They may well be OK for a while yet, but when the bond bubble bursts, a lot of people are going to get hurt.
Roger Bootle is managing director of Capital Economics.
Even if recovery takes hold, it will be a long time before the crisis of the public finances is under control. Indeed, the ratio of government debt to GDP will surely continue to rise for several years yet. During this time, it is vital that the cost of financing the deficit (and refinancing maturing debt) is kept low. This argues strongly for continued low short rates.
If the authorities ever resort to a policy of deliberately higher inflation to work down the real value of the debt, it would similarly be vitally important that bond yields stay low. Otherwise, even a burst of unexpected inflation would do little good as the markets quickly priced in higher inflation – and possibly even more inflation than was actually going to occur. The result would be a significant increase in the cost of financing the deficit, the end result of which could be that the debt to GDP ratio hardly came down at all, or even rose.
So the authorities would surely need to maintain very low short rates while simultaneously putting pressure on the banks, pension funds and insurance companies to maintain high ratios of bonds in their portfolios “for safety reasons”. This is exactly what happened in the UK and the US in the years immediately after the Second World War and it is already happening again now.
In other words, such a regime would involve sharply negative real interest rates and real yields. That is a substantial underpinning for the value of all sorts of assets, including residential and commercial property and equities. But, of course, the foundations for such resilience are distinctly dodgy, because eventually the bond bubble will have to burst. For equities and commercial property, the hope is that the recovery in the economy that would by then have taken place would be sufficient to outweigh the influence of higher bond yields. (Residential property would have no such support, unless the rate of increase of average earnings had taken off.)
But even if this were broadly true, the two would not happen smoothly in tandem, so it would be an extremely bumpy ride. And when bond yields rose, this would inflict huge capital losses on their holders, who would be dominated by these same banks, pension funds and insurance companies.
Of course, it is possible that the bond market crisis could occur sooner. The most likely cause of this, in my view, would be a surprisingly strong economic recovery. This is a situation where the first interest rate rise, even though it was only 0.25pc, would have a disproportionate effect as market operators speculated about how soon the next rise might occur.
Any change in interest rate perceptions would be extremely dangerous. Both individuals and the corporate sector would start to fret about the implications. The effects could be particularly serious in the housing market – just as it was entering a recovery phase.
This is why, despite the fact that some commentators are already warning of the need to put up rates soon, I suspect that the incoming Governor of the Bank of England will rather see his task as to ensure that people hold to the view that rates will stay low for an extended period. This will make a strong case for so-called forward guidance, where the central bank explicitly says that it does not expect to raise rates before some specified future date.
The exchange rate will also be a key factor. Last week’s trade figures were encouraging, but there is a long way to go to rebalance the UK economy towards exports and corporate investment. The last thing that we need is renewed sterling strength. Indeed, some good judges think that the pound needs to be even lower. If we soon raised rates here and/or began reversing QE, there would be a serious danger of sparking a sterling rally which would play havoc with our hopes of achieving a rebalanced economy.
If and when the euro crisis flares up again – and I am pretty sure that it will – you will see a flurry of funds pouring into gilts “for safety”. Yet, looked at over the medium term, gilts are just about the most unsafe asset around. They may well be OK for a while yet, but when the bond bubble bursts, a lot of people are going to get hurt.
Roger Bootle is managing director of Capital Economics.
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