Wednesday, September 3, 2014

Will the Bond Bubble Burst?

Unless inflation drops much more, now is an ideal time to be a borrower and a bad time to be a lender or investor in long-term bonds. Indeed, in many countries, exaggerated fears of deflation are keeping interest rates depressed and the cost of capital at historic lows.

The lowest rates were seen on June 13 th . Ten-year bonds in the US yielded 3.11%, not much above the 2.1% inflation rate of the past 12 months. Ten-year government bonds in the Euro-area yielded 3.54%, while the Euro-area inflation rate was 1.9%. The yield in the UK was 3.86%, while inflation was 3%, and Japanese bonds yielded 0.44%, compared with inflation of -0.1%.

In each case, a small increase in today's very low inflation rates would eliminate any real gain from investing in bonds. If low long-term rates do not hold, long-term bond prices will drop sharply, leaving investors with a loss.

The history of developed-country bond markets in the last half-century is relatively straightforward. Consumer inflation increased fairly steadily (albeit with major short-run swings), until the oil crises of 1973-4 and 1979-81 propelled it to historic highs in Europe, North America, Japan and other countries. Afterwards, the trend was reversed, and inflation declined fairly steadily.

The oil crises marked a political as well as an economic turning point. Until that time, central banks, fearing recession, were gradually losing their grip on inflation. But public anger over sky-high price growth precipitated by the oil crises finally allowed central banks to tighten credit and smother inflation with massive global recessions. Corporate managers, meanwhile, got the public support needed to resist many cost-of-living allowances that were fueling a wage-price spiral.

The general investing public never really understood these trends. They did not comprehend the upward trend in prices before 1980, so bond yields, lagging behind rising inflation, were too low. In the US, ten-year US Treasury yields averaged only 1.46% above the inflation rate between 1953, when annual average inflation was only 0.63%, and March 1980, when inflation peaked at 14.66%.

Nor did the investing public fully comprehend the downtrend in inflation after 1980, so long-term bond yields, lagging behind falling inflation, were too high. In the US, yields on ten-year Treasuries have averaged 4.14% above the rate of inflation throughout the period of declining inflation that began in April 1980.

The public's failure to recognize inflation trends meant that long-term bonds were a terrible investment until 1980, when inflation was only a little lower than yields, and a lucrative investment thereafter, when declining inflation and high yields guaranteed large real gains.

Investors are again making the mistake of pricing bonds in expectation that the downward trend of inflation will continue into deflationary territory. Indeed, today's low long-term rates suggest that investors are projecting the downward trend to continue over the next ten years at the same pace that it has done since 1980, implying that the current US inflation rate of 2.1% would fall to zero or below by 2013.

Is this reasonable?

Almost certainly not. No central bank would permit deflation for long, and the current level of inflation probably represents the lower boundary that most monetary authorities consider acceptable. At the same time, there is no such clear upper bound to inflation. So with inflation rates near their long-term lower bound, the expectation should be for higher , not lower, inflation rates over the longer term.

The current situation in the bond markets does not reflect this because of public overreaction to the talk of deflation, with Japan used as a scarecrow. But even in Japan, annual deflation has been only about 0.7% since 1998, and was caused by a monetary-policy error unlikely to be repeated. Japan is really the only example of advanced-country deflation in the post-1945 era. So why should bad policy by the Bank of Japan set the trend for world inflation rates?

Indeed, the opposite may be the case: combating deflation could have the perverse effect of creating high inflation. This is what Masuru Hayami, the former governor of the Bank of Japan, feared when he resisted calls for more monetary stimulus. He was right to worry: a sharply expanding money supply may have unexpected and unquantifiable lagged effects. The kinds of heterodox monetary policy that might be used to prevent deflation similarly risk an overreaction and renewed inflation.

But fear of deflation is so widespread nowadays that if inflation overshoots the target, central banks will merely try to stop further inflation, rather than try to bring the consumer price level back down which would mean deflation. Then any inflationary monetary policy errors driven by exaggerated fears of deflation will be allowed to stand, and the cumulative inflation will offset any returns on investments in long-term bonds.

Today's fears about deflation may represent a historic turning point, much as when the public mood turned decisively against inflation around 1980. Conventional wisdom has changed, and many people will be breathing a sigh of relief when inflation rates rise above 3% or more in the US and elsewhere.

If we have arrived at such a turning point, as the trend in bond markets in recent weeks might suggest, it will be a turning point for interest rates and bond prices as well. The current combination of exceptionally low yields and high prices suggests that much of the world is in a bond-market bubble, and when it bursts in coming years, a period of higher long-term interest rates and lower long-term bond prices will follow.

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