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In 2016, something extraordinary happened in global bond markets.
Bond yields in many cases had already turned negative. In other words, investors were paying governments for the privilege of parking their money in “safe” government debt.
But the pinnacle of this panic rush for safety came in July that year, just after the Brexit vote. At that point, the Swiss government was able to demand interest payments from its own creditors – for a 50-year loan.
Why am I bringing this up now? Because I thought that was the peak for the bond bubble. I still do.
But the way things are going just now, I think it’s not a bad idea to revisit some of those assumptions. Just in case.
Why would you buy a bond with a negative yield?
My working assumption has been that we saw the top of the bond market in mid-2016. That’s when prices were at their highest, and therefore bond yields were at their lowest (and in many cases, their most negative).
The final spasm of panic came after the Brexit vote. At that point, we saw the yield on Swiss 50-year government debt (deemed among the safest assets of all) drop to an all-time low of below zero.
Now we’re finding that the yields on government debt are once again turning negative. As the FT points out, the global stock of government bonds with negative yields “has vaulted back over the $10 trillion mark” for the first time since September 2017. That’s almost double the level of a year ago.
So what’s going on? Could we see yields turn even more negative? Will we see another new high for bond prices?
Let’s first consider why investors wanted to buy government bonds so desperately back then.
You might wonder why anyone would be daft enough to buy a government bond where you are actually paying the government interest, rather than the other way around. And you’d be right. But you’re failing to see the entire picture.
You see, people have and had been buying government bonds that have offered nothing but a loss in real terms (after inflation is taken into account) for years. For example, if you buy the 10-year UK government gilt right now, you get 1% a year, compared to official inflation of nearly 2%. That’s a losing proposition. So there is nothing particularly special about negative yields, beyond being visually striking.
So why would you buy a government bond that is costing you money? There are a few reasons but I’ll focus on two. One is that you think bond yields are going to go even more negative (so prices will rise), and so you’ll make money through capital gains. The other is that you think it’s the least-worst option on the table. You’d rather sign up to lose a little money every year, than own anything else.
Both of those bets add up to a belief that economic prospects are so poor – that we’ll be gripped by deflation and depression – that your best bet is to stick your money in government bonds, which are at least backed by the full weight of the central bank.
Markets are primed to believe another 2008 is just around the corner
Now we are still a pretty long way from the nadir of bond yields seen in 2016. The ten-year US Treasury bond (another classic safe-haven asset) fell to below 1.5% back then. It’s still up at around 2.4% today.
But clearly the path of least resistance for now is lower. So are we going to revisit the fearful peaks and troughs of 2016? Or are we even going to beat them?
My feeling is still no. I believe that the market is still overly primed for a repeat of 2008. It takes a long time for the psychological damage done by that kind of crash to wear off.
Folk wisdom suggests that an entire generation was so scarred by the Great Depression that they never invested in equities again. We are probably seeing something similar now.
So now that we’re facing a genuine growth scare – and possibly even a recession – markets are anticipating a return to the fearful days of deflation and government bond buying.
But not every recession has to be 2008. The vast majority are not. And we also know exactly which strategy will be used to get out of it: printing more money – and maybe giving it direct to voters this time around, depending on who gets to take charge.
I don’t think that will end happily, but I also don’t think it would be deflationary. Anyone who worries that central banks are “out of ammo” simply lacks imagination.
My real concern is the structural damage being wrought by low interest rates and our distorted monetary environment. Some economists are starting to wake up to the idea that perhaps our current monetary environment is the cause (rather than a symptom) of our various problems, such as low productivity, and a general sense of malaise and lack of progress.
Low rates and easy money damage competition, deter capital formation (why bother?), and as a result, damage efficiency (which is the only way our standard of living improves in the long run).
That’s all bad. And we’ll talk about it more later this week. But long story short – I still think the bond market hit its peak in 2016. However, I’m going to continue to keep an eye on it in our weekly Saturday Money Morning roundup. And if I start to think I’ve got it wrong, you’ll be the first to know.