Photo: The Economist
EQUITIES may be enjoying a bull run but the government-bond market has turned sour.Having bottomed at 1.67% in September, the yield on the 10-year Treasury bond has risen to 2.38%, with the sell-off accelerating in the past two weeks.
A rise in yields from what were very low levels, in historical terms, is not that surprising. The economic data have been better than expected since the start of the year, particularly in America, calming fears of a global recession. A torrent of central-bank loans to euro-zone banks and Greece’s debt-restructuring deal have made investors less nervous about a break-up of the euro, removing the appeal of Treasury bonds as a haven.
In this section
- The many stages of grief
- Self-sustaining stimulus
- The pendulum swings
- Ports in the storm
- Nudge nudge, think think
- Clanger: China’s economy
The big question is whether this is a turning-point in the bond market. The chart shows how the rise and fall of Treasury-bond yields over the past century-and-a-bit divides into very long phases. Chris Watling of Longview Economics points out there has been a remarkable regularity to the past three cycles—a 29-year downtrend, followed by a 32-year uptrend and another 31-year downtrend lasting to the present. This pattern is probably a coincidence but it does illustrate that bond-market cycles are rather longer than those in the equity market. Mr Watling points out that the early stages of bond cycles (1920-29, 1949-68 and 1982-2000) have been associated with equity bull markets while the latter stages (1929-49, 1968-82 and 2000 to date) have been associated with bear phases.
The big bear markets in bonds were associated with higher inflation. There was a brief inflationary period associated with the first world war and a much longer burst of rising prices after the second world war which culminated in the 1970s. Some fear the inevitable response to the current crisis is that countries will attempt to inflate away their debt.
But there is not much sign of this in the consumer-price indices. Inflation is expected to average 2-2.5% this year in America, Britain and the euro zone. And bond investors do not seem to be too concerned about the near future, to judge by the breakeven inflation rates (the gap between the yield on conventional and inflation-linked bonds). These reached a nadir of just under 1.5% (for five-year bonds) in September and are now up to 2.1%; for 10-year bonds, there has been a move from 1.7% to 2.4%. But those rates are still consistent with central-bank inflation targets.
There is a problem, however, with using market numbers to divine the mood of private-sector investors: central banks have been intervening heavily in the bond markets at both ends of the yield curve. Charles Kindleberger, a financial historian, long ago established that credit creation was a key component of bubbles. You cannot always tell where the bubble will emerge but central banks have given a big hint this time by buying the asset directly.
The policy is designed to revive the economy but the effect on investors, many of which are forced by regulations to hold government bonds, has been dubbed “financial repression”. By keeping rates low at a time of massive fiscal deficits, central banks are also reducing the pressure on governments to get their finances in order. “When a central bank actively seeks to keep yields below inflation in order to generate negative real interest rates, by implication it is imposing negative real returns on investors,” says Hans Lorenzen of Citigroup. “In so doing, it is ensuring that the sovereign can borrow cheaply.”
Another worry is how governments and central banks can return policy to a pre-crisis setting. In Europe attempts at fiscal austerity have been followed by deep recessions. Can central banks raise interest rates to normal levels of 3-4% without causing widespread bankruptcies? Can they withdraw liquidity support from commercial banks without causing a financial crisis? And can they offload their government-bond holdings without causing a very sharp rise in yields?
Given these risks, it is not difficult to construct a bearish scenario for bonds. Indeed, central banks were also holding short rates at very low levels at the last nadir for bond yields in the late 1940s (a moment when, as now, governments were trying to deal with accumulated debts).
But even if bond yields have touched the bottom for this long cycle, it is worth remembering that the period of low yields in the 1940s was quite protracted, lasting eight years or so. In the short term, if yields were to rise too far, to 3% or so, central banks could always step in with another round of quantitative easing. The great bear market in bonds may have begun but the decline will not necessarily be precipitous.