Government bond markets are supposed to be sedate places, devoid of the thrills and spills that characterise equities. Not any more. Since central banks started enlarging their balance sheets, sovereign bonds have become exciting to the point where investors have bought more than $2 trillion of them on negative yields, mainly in Europe.
Even in the Depression of the 1930s interest rates never fell below zero. Is this that rare thing – a bond market bubble?
Some economists argue the current low level of yields is justified by fundamentals, especially if we are confronting secular stagnation, whereby the rate of innovation is flagging and shortfalls of demand are such that near-zero rates of interest are incapable of reviving the economy. Yet to the extent that demand is weak, it is surely self-inflicted – the result of debt overhangs and tight fiscal policies.
As for innovation, pessimists on this score have invariably been wrong since the start of the industrial revolution.
Others suggest that perceptions about the scale and likelihood of extreme bad events have changed since the financial crisis and that people who thought of the implosion of the financial system as a one-in-100-years event may now think of this as a one-in-50- or one-in-25-years event. Certainly this provides a plausible explanation of why yields fell significantly after the crisis. Yet for this to explain the more recent phenomenon of negative yields, it would require the perceived risk of financial implosion to have vastly increased in the interim. Alternatively, the shift might be explained by heightened worries about geopolitical risk. Neither notion seems entirely convincing.
A simpler explanation is that a global savings glut is confronting a shortage of safe assets and that this imbalance of supply and demand is being exacerbated by the European Central Bank's move to quantitative easing.
Somebody has to be persuaded to sell their bonds to facilitate central bank purchases of €60 billion a month. Yet the obvious candidates have little incentive to do so.
Quantitative easing
In the case of banks, government bonds sit on the balance sheet to satisfy regulatory requirements for liquidity. Switching into more risky assets, which is partly what quantitative easing seeks to encourage, makes no sense for them.
Pension funds’ bonds are there because they are matching liabilities. Selling might result in a less closely matched portfolio. As for insurance companies, they too have regulatory requirements to satisfy. And if they reduce their existing bond portfolios, they can only reinvest at much lower yields or at comparable yields in much riskier assets. That is scarcely appealing.
That does not mean Mario Draghi, the ECB's president, will necessarily want for buyers, because he has taken the unusual step of telling the market he will purchase bonds yielding above the ECB's deposit rate of minus 0.2 per cent. In other words, he is a forced buyer.
As in any bubble, speculative investors will gamble on the prospect of negative yields extending to longer maturities in the knowledge that they have a guaranteed exit. Europe’s safest assets, German bunds, will lead the further plunge into negativity. Other less safe assets will follow.
If the essence of a bubble is that prices lose touch with fundamentals, that is where euro zone sovereign bonds are going. Market participants will be recycling government IOUs into the hands of the central bank regardless of relative risk. At the same time, the central bank-induced search for yield will reach new levels and create new distortions.
It is extraordinary that despite the very different monetary policies being pursued in the US and the euro zone, bond yields in both places declined after the ECB’s quantitative easing announcement. If negative yields do indeed extend to longer bund maturities, the wider spread between US and German IOUs will prompt a further big inflow of funds into the US bond market.
Indeed the traditional relationship whereby global markets dance to Wall Street’s tune is being reversed. There is a spillover from the euro zone bond markets into the US and the rest of the world.
All bubbles burst. Until that happens Europe offers cheap borrowing, at least for large corporations. If that fails to translate into higher levels of capital investment, the secular stagnation thesis may need to be revisited. – Copyright The Financial Times Limited 2015
