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A government bond is issued by a national government and is denominated in the country`s own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The yield required by investors to loan funds to governments reflects inflation expectations and the likelihood that the debt will be repaid.
The Australian bond yield looks like this today:
www.bloomberg.com.au 5/6/2012
This is called an inverted yield curve and is generally interpreted as a leading indicator of recessionary times. Orange line is yesterday, green is today. This afternoon's rate cut by the RBA in the official cash rate of 25 bps is in line with the bond market's expectations with the expectation of more to come.
The 12 month chart for the Australian Government 10 year bond looks like this.
www.bloomberg.com.au 5/6/2012
Australia's Government Bond Yield for 10 Year Notes have declined since October 2011 which means it became less expensive for Australia to borrow money from investors. Historically, from 1969 until 2012, Australia Government Bond 10Y averaged 7.9% reaching an all time high of 16.4% in May 1982 and a record low of 3.1% in May of 2012.
The international picture for bonds can be seen here:
www.ritholtz.com 2/6/2012
This week US government bond prices reached all time lows. German and Swiss bonds currently can be bought with a negative interest rate. Other than the obvious argument of "flight to safety", why would anyone want to buy sovereign debt with a negative return? John Mauldin writes here
But even given the pessimism in Europe, why should Germany be able to sell €5 billion of two-year bonds at zero percent interest last week and see them trade this week at a slightly negative interest? Why would anyone buy a bond that is guaranteed to not even give you your money back? Is that a sign of severe potential deflation?
The answer is, not really. Buying German bonds, even at a slightly negative rate, is actually a cheap call option on the eurozone breaking up. A German bond that became a new Deutschemark-denominated bond would rise in value at least 40-50% almost overnight. If you are a pension fund, for instance, with a lot of sovereign debt from a variety of European peripheral countries and you think a break-up of the eurozone is possible, it is a way to hedge your investment portfolio.
Switzerland actually sold outright this week bonds that have a negative coupon. Again, not a sign of deflation but another call option, betting that the Swiss Central Bank will have to give up on its peg to the euro. That peg has got to be one of the biggest losing trades in central banking history, and the Swiss seem determined to lose even more money. If the euro goes to $1.15 or lower, that trade becomes an even more massive loser. At what point in the next year will the Swiss Central Bank decide it has endured all the pleasure it can stand in fighting the fall of the euro? If they abandoned the peg, the move in the Swissie (as traders call the Swiss franc) would be large and almost instantaneous. And the reward for investors outside of Switzerland buying Swiss bonds with a negative yield will be large.
What about inflation?
We know PMI numbers are showing economic contraction. We know we are living in deflationary times. Australians are deleveraging fast - retail sales are down and we are paying back personal debt to the banks at very high rates. Unemployment in the USA and Europe is at persistently high levels. This leaves central governments around the world able to employ strategies such as Quantitative Easing without an immediate inflationary effect. Mauldin offers the theory that this is due to the slowdown in the velocity of money - for a fascinating explanation see here. For those without the desire to read more deeply, it follows from his argument that low bond yields are here for a long time and will not change quickly.
He says the Fed "will be able to monetize more than you think without causing a repeat of the 1970s. Eventually it will catch up to us, as there is no free lunch, but they are betting they will be able to reduce some of the actual inflation by cutting back on the money supply and raising rates. But we are years off from that. So, yes, at some point inflation will be back".
The following chart shows the US Federal Reserve's holdings of US government bonds and the timing of such purchases, relative to each wave of quantiative easing:
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| Deutsche Bank |
The significance of the above chart can be seen when reading, from Deutsche Bank:
In addition, central banks (Fed, ECB, BoE, BoJ) buying government bonds has lowered supply of risk-free bonds real money managers can buy (for example, the Fed currently holds 30% of all 5-10 year US Treasuries outstanding).
Bottom line: More demand for risk-free assets and less supply of risk-free assets combined with significant long-term risks to global growth imply that interest rates are likely to stay low for many more years.
...from JP Morgan’s Flows and Liquidity team on Friday, we have five reasons, other than quantitative easing, why rates will stay down for the foreseeable future:
- Regulations such as Solvency II, pension fund regulations, Basel III- It is not only regulations inducing financial institutions to buy bonds, demographics may also be playing a part
- Due to ultra low policy rates, retail investors replaced money market funds with bonds as savings vehicle- G4 central bank QE- An acceleration of the global savings glut since the Lehman crisis.- The end of the equity culture
What does a long term low priced bond environment mean?
Bottom line, for self funded retirees in Australia, it means that we are likely looking at a low yield investment environment over potentially quite a long time. This is not great news.
Jeremy Warner wrote in the London Telegraph in June 2011 (not much has changed in Europe in 12 months!):
The traditional relationship, which has ruled with only a small number of aberrations since the late 1950s, is that bonds yield more than equities. This juxtaposition is underpinned by the idea that equities are able to grow their earnings at least in line with GDP, and therefore over time will offer a better rate of return than fixed income investment.
The man most credited with creating this relationship was George Ross Goobey, who back in the 50s headed the Imperial Tobacco pension fund. By advocating equity investment as an appropriate policy for pension funds, he brought about a revolution in investment thinking.
Pension funds developed a previously non-existent appetite for risk and switched wholesale from fixed income into shares. The "cult of equity" was born. Shares began to yield less than bonds to reflect their supposedly superior growth and inflation hedging characteristics.
But what happens when growth slows, society ages and risk appetite diminishes? Well as it happens, bonds have been outperforming equities for many years now, but it was only with the onset of the financial crisis that the cult of equity's fifty-year reign started to crumble.
Post the Lehman crisis, we saw an extreme reversal in the yield gap, followed, after the policy response and signs of a spluttering economic recovery, by an uneasy truce, when the two yields essentially tracked each other. But since June this year, the relationship has gone unambiguously back into the post Lehman danger zone.
It's still too early to say this is the new normal. We are once more in one of those periods of extreme risk aversion, with multiple uncertainties crowding in on investors. It's not surprising that there should be a dash for safe haven assets.
In a downturn, corporate profits will fall, dividends will get cut and insolvencies will rise. Bonds, by contrast, become the default security of choice. Money that would normally be spent on consumption or invested in productive assets gets hoarded instead, generally in cash or the nearest equivalent, government bonds.
As risk aversion grows, a vicious circle establishes itself of falling demand, employment, and economic activity. The more risk averse that companies and households become, the more they save. In Japan, they've had this phenomenon for twenty years now and still there is no end in sight to the deflationary funk.
The mood is infectious; having let rip with deficit spending in the immediate aftermath of the Lehman's collapse, governments too are losing their appetite for further risk and are reining in as fast as they reasonably can.
It's hard to be bullish about prospects for equities right now. Investors won't return until uncertainties over the US and eurozone economies are lifted, and that's going to require a level of political leadership which right now seems entirely absent on both sides of the Atlantic.
Extreme volatility and sideways trading look set to remain the order of the day for some while. That's not to say equities are not worth buying. Some businesses prosper, even in a depression. But we seem to be going back to the old, pre-war days, when equity was priced for risk.
Equity is becoming scarcer, and therefore more costly, just at a time when large swathes of the banking and corporate landscape, not to mention the economy as a whole, need most.
Interesting times continue.
