Government bonds are being touted as the safest place for your money during the latter stages of this financial crunch. I’m no economist or financial adviser, but I think that’s a load of baloney.
Cash is the way to guarantee preserving the nominal value of your wealth (inflation and bank runs aside).
Government bonds are assets that fluctuate in value. Just like any other asset, making or losing money with government bonds boils down to:
- The price when you buy them
- The price when you sell them
- The income you get from holding
Government bond yields have plunged. At the time of writing:
- Long dated yields in Europe and the UK are at their lowest in 50 years
- The yield on the 10-year German Bund is below 3%
- 10-year Gilts in the UK dropped from 3.77% to 3.32% in a week
- US 10-year Treasuries touched a 53-year low of 2.52%
- 30-year US Treasuries yield only a little over 3%
- Short-dated US Treasuries are yielding less than 1%
Priced to imperfection
The corollary of falling yields is rising prices. Another way of saying ‘yields have plunged’ is ‘the price of buying bonds has gone up’.
If you pay more for your government bonds than their face value, you will experience a capital loss if you hold them to maturity. If you want to avoid this, you need to expect to be able to pass them on to another investor before then.
Long-dated UK Gilts are as expensive as they’ve been since just after the Second World, and you’re paid a pittance for holding them. Do you really fancy your chances of selling them for a profit?
Is it rational to expect a 3% yield to compensate an investor for the next 30 years? Will inflation never again hit 4/5/6%? In my humble opinion these yields and the resultant prices are absolutely bonkers.
Dividend yields in the UK from the FTSE All-Share are substantially higher than Gilt yields. In a theoretical sense, Gilt investors are saying equity investors can have all the likely growth in the dividend yield to come for free. As David Stephenson of Wise Investments told CityWire:
On a valuation basis, markets appear even cheaper than they were a month ago. The UK Equity Market is yielding 5.5% and the Gilt/Equity yield ratio has fallen to 0.79, a massive 20% below where the market reached in 2003, the bottom of the last bear market.
Government bonds will surely look ridiculously over-priced at some point in the future, and buyers now will get burned. As the Financial Times writes:
With the yield on the 10-year US Treasury note falling below 2.70 per cent to its lowest level since 1955, traders are saying it is easy to think that government bonds no longer reflect long-term fundamentals. The yield has fallen by more than 100 basis points in a month.
“It’s a bubble as over the long term these low yields are unsustainable,” says Dominic Konstam, head of interest rate strategy at Credit Suisse.
“At some point the Fed will exit its liquidity programmes and there is no way these interest rates are sustainable.” […]
“People who lost money in stocks are now lending money to the US government for 30 years at a yield of 3.30 per cent,” says Rick Klingman, managing director at BNP Paribas.
“We are starting to get to levels [in yields] that are very low and could ultimately hurt investors.”
Any coffin in a storm
It doesn’t take a rocket scientist, let alone a humble blogger, to see why bond yields are falling.
The market is gripped by extreme fear and paranoia after numerous financial failures, market plunges, defaults and bank runs.
The fact that the consensus in the markets just 18 months ago was that house prices could never fall, money was cheap and happiness was a warm bank loan – the complete opposite of the mood today – can only make traders even more confused.
Talk of deflation stalks the corridors and trading desks. The mere mention of the word ‘Japan’ sends tumbleweed blowing across the floor.
As official bank rates fall towards 0% and inflation is expected to follow, government bonds yielding even 1% seemingly offer weary investors positive returns without the risk of waking up to discover a portion of your portfolio became worthless overnight.
What’s more, the US government is likely to formally begin buying back its own debt soon, to inject even more liquidity into the system and so drive down long-term interest rates:
“Although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest-rate policies to support the economy is obviously limited,” Bernanke said in remarks to the Austin Chamber of Commerce.
One option is for the Fed to buy “longer-term Treasury or agency securities on the open market in substantial quantities,” Bernanke said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”
In this he’d be following the more advice from beyond the grave from Keynes.
So low is the appetite for risk that some US commercial banks (who surely nobody now believes are prudent investors) are actually lending back the bail-out money they’ve been given by the US government by buying US treasuries yielding less than 1%, rather than lending to consumers at 5-6%!
These are certainly crazy times.
Treasuries will get massacred if inflation returns
The Federal Reserve’s Ben Bernanke is desperate to avoid deflation, and having studied its terrible consequences he will do anything to avoid it – even risk creating the sort of liquidity lake that led to the last credit boom.
But what will his actions lead to?
Inflation.
Not soon, perhaps not even next year, but the unprecedented sums being pumped into the system – historically low interest rates in the US, Europe and elsewhere allied with big stimulus packages – will stave off the deflationary threat.
After that, it’s back to inflation. And with 10-year issues offering just 3% yields, you don’t need much inflation to give you negative returns, even leaving aside the potential opportunity cost of being out of a resurgent stock market.
I’m buying what’s cheap, not what’s popular
I’m not saying these measures by central banks will lead to a solid global recovery. (I suspect they will in time, but that’s another issue.)
What I’m saying is we write off inflation at our peril.
It was only a year ago that newspapers were raving about the era of $200 oil and unaffordable tortillas. I was arguing with friends about whether the West should give up its cars and send food to Asia. And don’t ask me about my gas bill!
Yet while China, India and the rest of the emerging world have hit a road bump, they’re going to go on emerging. Many resources remain finite. Things that are scarce will rise in value again.
I fully understand that the financial system is deleveraging, and that many asset prices were over-valued. As a long-time housing bear how could I not?
But a US recovery can only really begin when house prices stabilize, so I think the Fed will keep injecting money until house prices bottom out. And when they do, the authorities won’t be able to flick a switch to keep inflation at a nice 1%. When inflation takes off, treasuries on current yields will be about as popular as an investment banker in Washington.
It will be a similar story across the world.
Just another investment bubble
I hope this doesn’t come across as one of those ranting bear essays you read on the Internet. I happen to think the Fed is doing the right thing.
I also think recessions are:
- normal
- helpful at preventing the spectacular misuse of capital we just lived through
- survivable
- painful (unfortunately)
The economic cycle, in other words, lives on. It wasn’t abolished when UK prime minister declared he’d “ended boom and bust” a few years ago, and it hasn’t ended now Lehman Brothers is no more.
Rough times lie ahead, sure, but well before they’re over investors will have regained their animal spirits, and the strongest companies will be reporting 25%-plus earnings per share growth a year.
I think markets are the cheapest they’ve been for decades. The P/E on the FTSE 100 over the weekend was just 7.5 (and yes, I realize that the earnings’ side is likely to fall, but this uncertainty is the price you pay for buying a bargain). That’s almost comparable to the 1970s’ bottom.
Being bearish has paid off for 12 months now – and I confess I’ve kept buying into the market all the way down. But being bearish can’t and won’t pay off forever. Investors will get over it. With these crazy yields on government debt it’s getting too expensive to be a bear.
I believe the West can avoid deflation, and so I’m buying cheap equities, not expensive government debt.
Give me a prod when Gilts yield 5% and I’ll take another look. Until then, for security an allocation of cash held in a current account suits me fine.
