Investor/An insider's guide to the marketsAt the beginning of the Millennium, interest rates and bond yields had reached levels that were low by the standards of the previous two decades.
At end-2000, short-term interest rates were about 5 per cent in the euro zone and just under 6 per cent in Britain and the US.
At the time, 10-year government bond yields in each of the British, US and euro-zone markets were trading around the 5 per cent mark. Since then short-term interest rates have declined to ever lower levels, led by a US Federal Reserve that seemed desperate to avoid a recession.
By end-2002, US three-month money was quoted as low as 1.4 per cent compared with three-month euro rates of 2.9 per cent and sterling rates of 4 per cent.
In the early months of this year, interest rates have fallen further (see table) and, at the time of writing, the European Central Bank was widely anticipated to cut interest rates further at its regular imminent policy meeting.
Despite global short-term interest rates at 40-50 year lows there is very little sign of any reversal in this downward trend. In fact interest rates could go even lower over the balance of the year depending on the outcome of any Middle Eastern conflict and the performance of the global economy.
Yields on medium-dated and long-dated government bonds have been much slower to come down once they reached the 5 per cent level.
As can be seen from the table, 10-year government bond yields continued to hover around 5 per cent in all three currency zones during 2000 and 2001. It was only during 2002 that bond yields finally moved down to trade around 4.5 per cent and during 2003 yields they have moved down decisively to trade around the 4 per cent level.
With inflation in the 2-2.5 per cent range, bond yields of 5 per cent were offering inflation-adjusted or "real" long-term yields of 2.5-3 per cent. This real yield is in line with long-term norms, indicating that long-term bonds were offering reasonable investment value.
Although inflationary pressures have eased somewhat, long-term inflation expectations are still probably in the 2-2.5 per cent range. Therefore, a bond yield of 4 per cent means that investment in bonds is offering the prospect of a "real" return of only 1.5-2 per cent per annum. Such a low real yield offers investors in bonds little protection against any unexpected future bout of inflation.
The question must be asked as to why investors are prepared to accept such low yields on government fixed-interest securities. A ready explanation cannot be found with regard to the likely supply pattern of government bonds. Up to recently, many governments were enjoying a phase of budgetary surpluses. This was particularly true for the US and Britain, leading to a sharp reduction in the supply of new British and US bonds.
But budgetary surpluses have turned to deficits in most countries. Indeed, the scale of the borrowing needs of governments is growing rapidly. Therefore, the authorities across developed countries will be forced to issue ever-increasing amounts of government bonds in coming years in order to fund burgeoning fiscal deficits. In view of these official borrowing trends, it is all the more surprising that long-term government bond yields have continued to decline.
The explanation for falling bond yields must lie on the demand side of the equation. There would seem to be two main reasons as to why there may be ongoing strong demand for government bonds.
The first lies in fears that the global economy could be headed for a long period of deflation. The second relates to the fact that investors generally have become more risk-averse after three years of declining equity markets.
While the prospective returns from government bonds may be low, those returns are guaranteed if the relevant bond is held to its maturity date. Therefore, a flight to safety seems to be one important factor causing investors to allocate a much higher proportion of funds to government bonds. Such a trend seems to be now well entrenched and is likely to last for a prolonged period.
With regard to the risk associated with global deflation, those that adhere to this view point to the experience of Japan from the early 1990s to date. There the bursting of a stock market bubble has been followed by 10 years of slow growth and, at times, a falling overall price level. In a period of deflation, short-term interest rates are pushed close to zero (or even negative) and long-term bond yields reach extremely low levels.
Rates of economic growth and inflation have been declining in Europe and North America for some time, although inflation and growth are still significantly positive. The risks of deflation have risen, although the majority view remains that such an outcome can be avoided. The consensus view would seem to be that slow growth and low rates of inflation will be the order of the day for the foreseeable future.
On balance, the demand for bonds from investors is likely to remain strong due to their predictable if somewhat low returns, plus the protection they offer if the global economy drifts into a deflationary spiral.
