A toxic mix of central bank intervention, ultra-low inflation and yields and historically high sovereign debt has spawned a bubble in bonds, say Deutsche Bank strategists Jim Reid, Nick Burns and Seb Barker in their data-heavy but comprehensive research note ‘Long-Term Asset Return Study-Bonds : The Final Bubble Frontier? ’ of September 10.
“We think this year’s main conclusion is interesting as although we’ve been in the low yields for longer camp for some time (and still are in the near-term), we do think bonds are starting to exhibit bubble tendencies with very little value for investors trying to create long-term real returns,” they say in their annual study note.
Central banks and governments across the globe embarked on a series of fire-fighting responses that started with crises such as the Asian meltdown, the LTCM crash and the Russian default in the late 1990s. Unfortunately, each such policy response, usually fiscal in nature, birthed yet another bubble-like crisis, only larger the next time. The global economies lurched from the 2000 stocks crash to the housing-led great financial crisis in 2008, the European sovereign debt crisis in 2010-2012 thereafter, and most recently, to the murmurs on China’s credit defaults – serial bubbles that circled the globe akin to a hot potato party game.
“With no obvious areas left to inflate in the private sector, these bubbles have now arguably moved into government and central bank balance sheets with unparalleled intervention and low growth allowing it to coincide with ultralow bond yields,” says the Deutsche Bank research study, noting that as an asset class, government bonds held the dubious distinction of being the bubbles’ current resting place.
About bond yields and inflation
Government interventions in the form of asset purchases and interest rate reductions have pushed government bond yields to historical lows.
“The majority of major Government bond markets across the world (especially in DM) have hit multi-century all-time yield lows over the past two years,” says the study, observing that “European Government bond yields are currently at around half a millennia all-time lows.” The phenomenon is a strong argument for the case that government bonds may be displaying bubble-like symptoms.
But systemic and low inflation could also trigger low bond yields. Interestingly, the study finds that in modern times, the percentage of countries reporting negative inflation rates has fallen to all-time lows, as shown in the chart below. The Deutsche Bank analysts call this a positive inflation bias.
A computation of the median global year-on-year inflation since 1800 is shown in the chart below.
“Indeed we haven’t seen a year of deflation on this median Global YoY measure since 1933, meaning we’ve now had over 80 years without a global year-on-year fall in prices even if the annual rate of inflation has been falling fairly consistently since the mid-1970s,” say the DB strategists.
The above data raises a red flag for bond investors indicating as it does that inflation has been ensconced in a global trend that has an upward bias, increasing the chances for a sudden jump in yields that could puncture bond prices.
Economic stagnation and governments’ ability to meet their obligations
The Deutsche bank strategists also point to the risks of a secular stagnation (such as in Europe) that could compel governments to engage in further stimulus measures that might eventually result in rising inflation, though at the cost of their ability to meet their bond obligations. They point out that the average G-7 ratio of debt to GDP is already ruling at historical highs (after WW II) with yields at all-time lows.
Failure to meet bond obligations could result in a sovereign restructuring with a consequently devastating impact on the bond market.
Bubble in bonds: But don’t head for the panic room…yet
According to the DB strategists, global central banks/governments have a vested interest in low bond yields considering they need to tap the bond markets as an important funding source given their current indebtedness.
“There is no obvious end in sight to the bond bull market, but the risk/reward is becoming more asymmetric as investors are at risk from either inflation or in more extreme circumstances future restructuring if we’re stuck with long periods of substandard growth,” advises the report.