The most striking thing about financial markets at the start of 2009 is neither the level nor the valuation of stock markets, which are well within historical norms. Nor is it oil prices. Had investors been told two years ago that crude would cost around $50 a barrel, their flabbers would not have been gasted, as Frankie Howerd, a comedian, used to say. What is remarkable is the level of nominal government-bond yields.
Two-year Treasury bonds yield less than 1 percent. The 30-year bond was, as recently as January 2nd, yielding less than 3 percent. James Montier of Société Générale cites figures showing that ten-year Treasury yields have averaged just over 4.5 percent since 1798. Today they offer just 2.5 percent.
When commentators say that some assets look cheap, they tend to use low government-bond yields as their benchmark. Corporate-bond yields are not that high in historical terms. It is the spread they offer relative to government bonds that is extraordinary. And at 3.3 percent, the dividend yield on the American stock market hardly seems mouthwatering, but it is higher than the long-term Treasury-bond yield for the first time since the 1950s.
All this is occurring when Western governments are conducting an immense economic experiment, with vast fiscal stimuli accompanied by monetary expansion. In the medium term, a sharp rise in inflation is a distinct possibility. Government bonds may be offering “return-free risk,” in the neat phrase of Jim Grant, a veteran newsletter publisher.
One warning sign is that real bond yields (as measured by the inflation-linked market) have risen. Some believe this move has been driven by expectations of low inflation (or deflation) in coming years. But it may also suggest investors think the long-term fiscal position of many governments is not sustainable.
Indeed, nominal bond yields have also moved higher in recent days. Ominously, an auction by the German government of ten-year bonds on January 7th failed to attract sufficient buyers to raise the full amount targeted. The auction was the second-worst on record.
In the near term, bond yields are constrained because they reflect expectations of the future level of short-term interest rates. The Federal Reserve has pegged official rates at 0-0.25 percent and vowed to keep them low. The Fed has also talked about intervening directly by buying Treasury bonds to hold yields down.
Nor is there any immediate inflationary danger. In both America and Britain there is a chance the headline rate will go negative later this year. Many developed economies are in recession and the consensus expects 2009 to see falling output in America, the euro zone, Britain and Japan.
“Global bond yields are sure to be much higher in five years than they are today, but this does not imply that the market currently is in a bubble,” says Martin Barnes of Bank Credit Analyst, a research group. “The economic backdrop will remain bond-friendly for at least the next six months.”
This leaves investors with a dilemma. In the short term, they may like government bonds for the security they offer. Treasury bonds outperformed the S&P 500 index by an incredible 53 percentage points last year. But if yields are heading back to 4-5 percent (or even higher) by 2011 or 2012, at what point do they sell? The rational investor would want to get out of the asset class before the herd decides to do so. The logical extension of that argument (assuming most investors are rational) is to sell now.
But what if Japan provides the template? Many people thought Japanese bonds were overpriced when yields fell to 1-2 percent in the late 1990s. They have stayed around that level for the past decade, despite a vast amount of issuance (at $8.7 trillion, according to Bloomberg, the Japanese government-bond market is the biggest in the world). Even the expected $2 trillion of American issuance this year will leave its debt well below Japan’s.
The crucial difference, however, is that Japan has been running current-account surpluses, not deficits. The Japanese owe the money to themselves whereas the Americans are in debt to foreigners. Such investors could lose twice over: yields could rise and the dollar could depreciate.
For the moment, the balance is maintained by what Nick Carn of Odey, a hedge-fund group, calls “mutually assured destruction.” If overseas investors seek to sell their bonds, they will not only ruin the American economy but the value of their existing portfolios as well.
It is a precarious balance. It may well hold through 2009 and even 2010. But at some point, government bonds will surely suffer a horrendous bear market.