Today I want to take a brief step back from all the election excitement, and look at another area of the global economy.
There’s a lot going on out there, and it’s not all directly related to who ends up running Britain next month.
But it could certainly give our incoming government the biggest headache of their administration.
I’m talking about the bursting of the bond bubble…
The biggest lie about bubbles is that no one sees them coming
There’s a persistent myth about bubbles, which is that no one can see them until they burst. This myth clings on because it’s convenient for everyone to believe it – from central bankers who take a ‘see no evil’ view, to asset managers who like to hide behind a shield of collective ignorance.
The truth about bubbles is that they’re blindingly obvious. What happens is that people ignore them. Why? Firstly, it’s often in their best interests. If you own something, and it’s going up fast, then who cares how overvalued it is?
Secondly, there’s self-doubt in the face of the crowd. You might be able to see that logically something is a bubble. But how can it be, if everyone else is buying? What have you missed?
It’s exactly like the Emperor’s New Clothes. The point of that story is that everyone could see that the emperor was naked. It was just in their best interests to agree that he wasn’t. (Not to mention that in the real life version, the overly-observant small boy would have been tossed in a dungeon somewhere as soon as he opened his mouth).
This leaves bubble markets in a very vulnerable state. At one level, most of the participants, barring the minority of wild-eyed innocents, know that it can’t last. So they all have an eye on the exit – at least sub-consciously.
It’s also the reason why it doesn’t take anything specific to pop a bubble. The dotcom bubble was very clear to plenty of people before it burst, and with hindsight it’s even more obvious. But why did it top out on that specific day? What was the turning point, the inciting incident? No one knows.
We’ll be saying the same for the bond bubble when it finally pops. And yesterday we got some signs of how suddenly things can move when they do start to slide.
The slide in German bond prices
The yield on German ten-year government debt shot up by the most in two years yesterday. Bund yields rose from 0.17% to close at 0.29%. That may not sound extreme, but it’s a big move for the bond market. It doesn’t take much of a move to wipe out all your income when yields are this low. And that matters in a market where income is traditionally a key part of returns.
Why did it happen? If you had to point to something specific, it’s probably that German inflation rose faster than expected in April. Rising inflation is bad news for anyone holding bonds. Particularly when you’ve bought them on a yield of near-zero.
It probably didn’t help that Bill Gross recently called bunds the ‘short of a lifetime’. And yesterday his rival bond guru, Jeff Gundlach, also talked about putting a leveraged short bet on bunds. In other words, both are betting – or certainly talking about betting – on yields going up, and prices going down.
As Salman Ahmed of Lombard Odier told Bloomberg: “These are influential voices that offer a contrarian view when the German bond market appears to be at an extreme level, so there’s definitely going to be an impact on the market”.
At the end of the day, it doesn’t make sense for German bunds to be this low if the economy is strong (which it seems to be) and inflation is picking up. And in the absence of the promise of European Central Bank quantitative easing, they probably wouldn’t be this low.
That sort of logic leaves buyers and holders jittery. Anything could trigger further falls. “The point is that a cascade of small events is leaving a large splash in a structurally ever thinner bond market,” as Christoph Rieger of Commerzbank told the FT.
James Ferguson of the Macrostrategy Partnership has looked at the dangers posed by a bursting bond bubble for us. It’ll be in the next issue of MoneyWeek magazine (out on Thursday rather than Friday for next week only).
The threat to Britain from rising bond yields
The risk of course, to any incoming British government, is that a broad bond market sell-off wouldn’t spare anyone (the yield on ten-year gilts also picked up yesterday while bunds were selling off).
During the 2010 election, Britain’s fiscal state was a major political issue. Today it has sunk into the background somewhat, with parties more keen to talk about tax they’ll cut or what they’ll spend more on. But we are still hugely indebted.
Any broad-based rise in interest rates could be very painful indeed, particularly if we get a government whose commitment to fiscal responsibility is in doubt.
That’s why you need to have a plan in place for what to do with your money. Which is why subscribers should make sure they’ve signed up for MoneyWeek’s election action pack – if you haven’t read it yet, take a look at it now.
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