Government debts, bail-outs and stimulus programmes are putting pressure on the bond market. Is it heading for disaster? David Stevenson reports.
Why are bond markets vulnerable?
Because of how governments and central banks responded to the financial crisis. Central bankers slashed interest rates almost to zero. And governments have borrowed big. Some of this went on bailing out banks; Bank of England governor Mervyn King puts the total cost of Britain's bank support programme alone at more than £1 trillion. And as more cash has been spent on 'stimulus' packages, the net result is soaring public debt in the US, the UK and Japan.
"The advanced countries are deep in the financial mire," says Edward Chancellor in the FT. "According to the IMF, their national debt average is around 110% of GDP."
Further, "unfunded liabilities" – such as pension and healthcare costs – "are several times larger than officially reported national debts". But the cash has to come from somewhere. And global bond investors – who normally plug the gap – could balk at being asked for it. In other words, we could be on the brink of a bond market blow-out.
What does it take for a blow-out to occur?
The more loans a borrower takes on, the less creditworthy he is. And the risks lenders run in advancing extra money to that borrower then rise. This ultimately applies to governments as much as any other debtor. "The financial crisis hasn't so much been overcome as transferred from the private sector to the public sector," says Roger Bootle of Capital Economics. "For the time being this makes people feel better, but there's no such thing as a free crunch."
As America, Britain and now Japan have low savings rates, they'll become ever more dependent on foreigners rather than domestic savers to finance their debts. "For the first time in post-war history, Japan [which used to have a high domestic savings rate] will be feeding at the same trough of global savings as the US and the UK", says David Roche of Independent Strategy. "An unprecedented 25% of current global savings will be sucked up by government debt-financing for nations in the OECD."
If the major global sovereign bond investors, such as the Chinese – who own $800bn of US Treasury securities – decide they want extra compensation for the extra risks they'll be taking in buying more government debt, they'll demand higher returns.
What would that mean?
The coupon, or interest rate, that will have to be paid on new issues of long-term sovereign bonds will have to be higher, maybe even a lot higher, than recently. "With even a modest recovery in private-sector credit demand," says Roche, "as inflation expectations gain hold, bond yields will rise back towards at least the average level of the 1990s and perhaps even higher."
This means the values of existing government bonds will plunge. That is because the income stream they produce will become less valuable to investors than before, so their market price must now fall to attract fresh buyers.
Is that it?
No. It will also hit prices in the corporate bond market. Higher sovereign bond yields would drive up overall long-term lending rates, meaning corporate bond yields will also have to rise. That will make borrowing for business investment more costly, meaning the private sector is likely to get 'crowded out' by the sheer weight of government borrowing. That is bad news for economic growth.
There's another sting in the tail, too. If long-term interest rates rise to levels higher than a country's long-run growth rate, public revenues won't be enough to keep up with the state's interest bills. "When this happens, the fiscal position becomes untenable and the debt spirals upwards," says Chancellor. "This has been the case in Japan for several years." So taxes then have to be sharply hiked – if at all possible – to plug the hole.
Is there any good news?
It sounds like a paradox, but there could be some silver linings. Firstly, the latest crisis was caused by a credit bubble, so higher borrowing costs would deter a repeat.
Second, governments would be forced to slash spending, eventually helping long-term economic and job growth by freeing up space for productive private-sector investment.
Third, shares tend to fall when long-term interest rates rise, because safer investments now offer more attractive returns than before. So stockmarkets that have been pumped up by all the extra government cash (see below) would drop back, stopping another asset bubble getting out of hand.
Fourth, Britain's pension funds would benefit, because higher bond returns cut the amount of capital they need to meet their liabilities.
And fifth, higher long-term rates would filter through into raised mortgage rates. That in turn would help prevent more housing bubbles re-inflating.
Why hasn't a bond blow-out happened yet?
Central banks, via quantitative easing (QE) – buying bonds with electronically created cash – have pumped the equivalent of 6%-8% of GDP into commercial banks. Instead of lending it, banks have hoarded it or invested in government bonds. "That keeps everyone happy: politicians get cheap money, commercial banks make money and central banks keep the system liquid", says Roche.
But as Dylan Grice of Société Générale points out, in US history, long-term bond yields have been lower than today's on just two occasions, and neither lasted. The longer QE goes on, the more worried investors will be about inflation re-igniting.
The catalyst for a panic is impossible to predict, but "our government's actions are inconsistent with long-run stability," says Grice. "Not being able to predict a crisis trigger doesn't mean there isn't a crisis trigger." |
