Why government bond markets have become the latest mad and bad asset bubble

By Jeremy Warner Economics Last updated: October 22nd, 2010

The five year gilt yield has fallen to a new low (Photo: AP)

The benchmark five year gilt yield fell to a new low of 1.43 per cent on Thursday, which astonishingly takes it to a 25 basis point discount to that of its German bund counterpart. The UK Government likes to think of the record lows to which gilt yields have sunk to be a vote of confidence by international investors in its plans for fiscal consolidation, and no doubt there is a small element of truth in this contention. But the main factors driving government bond yields ever lower, not just here in the UK, but in the US too, are much more worrying and have little to do with the bravery of George Osborne’s deficit reduction programme.

In essence, both the UK and US government bond markets have become giant bubbles which are now largely divorced from underlying realities and almost bound to end badly. Yes, for sure if the UK Government hadn’t done something about the deficit, then we might be looking at far less benign conditions in the gilts market, but just to repeat the point, it’s not really enhanced credit worthiness which is causing these abnormally low yields.

The US is experiencing much the same phenomenon, even though its public finances are in just as big a mess as the UK’s and it has virtually no plan that I can discern for deficit reduction, besides the wing and a prayer hope that growth will eventually come to the rescue.

So what’s really driving this dash for government debt? One possibility is that bond markets are already pricing in a depression, or at least a Japanese style lost decade of deflation. Despite ever more mountainous quantities of public debt, bond yields in Japan have been at abnormally low levels for years. Indeed, in Japan the abnormal is now normal. If you think the price of goods and services will soon be deflating, then even bonds on 1 per cent yields offer a healthy rate of return.

But no, the real reason lies in the market distortions that result from ultra easy monetary policy and the demands being put by regulators on banks to hold “riskless” assets. This is leading to a profound mis-pricing of government bonds, which now take virtually no account of significant medium term inflation risks.

If you think markets are always right, then bond prices are indeed signalling the inevitability of a depression, but if there is one thing we have been forced by the events of the last three years to relearn about markets it is that they are prone to episodes of extreme mispricing. The bond phenomenon is very likely one of them.

There are a number of ways in which bond markets are being distorted. One is regulatory demands on banks to hold bigger “liquidity buffers”. The asset of choice in boosting these buffers is government bonds. These have already been proved by Europe’s sovereign debt crisis to be very far from the “riskless” assets of regulatory supposition. Even so, banks are still being forced to max out on government debt.

A second distortion is caused by the “carry trade” opportunities of exceptionally low short term interest rates. Put crudely, you can borrow from the central bank for next to zero, lend the money out at a higher rate further up the yield curve, and pocket the difference. In a sense, that’s the purpose of ultra-easy monetary policy – to create a generally low interest rate environment – but the dangers of it are obvious. Central banks are creating a bubble in government debt.

And so to the biggest reason of the lot. Look at the chart above (created from Bloomberg data), which shows the yield gap between the five and thirty year gilt, and you can see that it has widened substantially over the past year. The reason is that investors are anticipating another bout of quantitative easing from the Bank of England. In the last round of QE, the Bank concentrated purchases initially on UK gilts in the five to 25 year range, but then widened this to include three year gilts and some 25 year plus bonds after running up against supply constraints. Investors are buying up the five year gilt because they know this is where the Bank, if it does more QE, will find most scarcity. Exactly the same thing is happening in the US, where more QE is already pretty much a done deal.

Anyone with half a brain can see that Germany is a rather more credit worthy and naturally inflation proofed country than either the UK or the US, yet the cost of five year money in Germany is now higher. How can this be? The explanation lies in the absence of overt QE in the eurozone. There have been no purchases of German bunds by the European Central Bank.

In fighting the aftermath of the last bubble by flooding the market with ultra-cheap liquidity, the Fed and the Bank of England seem only to be inflating new ones. There are others besides government bonds, commodities and emerging market assets being the most obvious. I’m not saying these policies are as a consequence flawed and wrong. That wider debate involves an altogether more complex and diverse range of issues. But the risks are self evident.

http://blogs.telegraph.co.uk/finance/jeremywarner/100008271/why-government-bond-markets-have-gone-mad-and-bad/