Name an investment that offers little return and a lot of risk. Government bonds, says James Grant, editor of Grant’s Interest Rate Observer. Whether you look at US Treasuries, UK gilts or Japanese government bonds (JGBs), the market is looking pretty bubbly. Investors have stampeded into the only asset class deemed effectively ‘default risk-free’. So government bond prices have shot up, squashing yields to a paltry 1% in Japan, 2% in America and 3% in Germany.
Fear may well continue to buoy government debt prices for the time being. But although investors remain wary of investing in anything not backed by taxpayers’ capital, Pimco’s Mohamed El-Erian warned in a Barron’s article last week, “Get out of Treasuries. They are very, very expensive.”
And there’s a second reason to avoid investing in these bonds. Given the amount of money pledged by Barack Obama’s coming stimulus package, investors are starting to fret about inflation. To fund the package, the US government plans to float $1.7trn of Treasury debt in 2009, says the FT. That’s 12% of GDP and double the previous high set in 1983. The accompanying “quantitative easing” – printing money – could unleash an inflationary wave of extra cash into the economy. And higher inflation would wipe out the fixed-income-based low yields offered by most government bonds.
Of course, similar arguments were made in the 1990s when shorting Japanese government bonds was a popular play, says the FT’s Alphaville. Zero interest-rate policy could not last, it was argued, because inflation would return. It didn’t. However, the sheer scale of Obama’s stimulus package is unprecedented, while at €50bn (£45bn), Germany has already approved its biggest stimulus plan since World War II. Inflation may be difficult to avoid – in fact, at first it would be positively welcomed by most governments. But eventually it would result in a rush out of fixed-income government debt, driving yields higher. So while “there may be a ‘speculative’ case for continuing to hold bonds, there isn’t an investment case”, says Société Générale’s James Montier. A collapse in bond prices could also result in the dollar being devalued. The resulting “crash in paper cash would reinstate gold as the ultimate cash”, says John Browne in the Pittsburgh Tribune Review. “The brunt of ridicule, old-timers often kept gold coins in shoeboxes under their beds. It might not be such a joke by 2010.”