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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.