The Bond Bubble

Trillions of dollars of investment wealth has been funneled into a black hole of debt, over the past five years, in a frantic search for a decent return on capital and what has been perceived as a relative low risk asset compared with other asset classes. Indeed, the trajectory of the bond market has followed pretty much one direction over the past five years; that’s up and up and up.  To quantify this in money terms, had you invested say, 10,000 pounds sterling in an average strategic bond fund five years ago it would be worth today approximately 15,500 pounds sterling. 

There are several factors which may have caused the bond market to behave like it was on steroids. For example, following the financial crisis of 2008 there was a flight to safety away from riskier asset classes. In other words, there was a net capital inflow into bonds and a capital outflow from equities as investors reconfigured their portfolios to reflect the, then volatile financial environment. So the demand for bonds over more risk alternative  asset classes, such as equities, drove bond prices higher and interest rates lower; due to the inverse relationship between bond prices and yields.

The lower interest rates also meant lower returns for investors on their high street bank deposit accounts. This made alternative less risky investments such as bonds more financially attractive, which in turn drove up the demand for bonds and their price.

Moreover, expansionary monetary policy was rigorously implemented by the US Federal Reserve and the Bank of England during the financial meltdown of 2008 in an attempt to choke off a depression. This is supply side economic thinking favored by centre, centre-right governments. The idea is to stimulate the economy, or in the case that preceded the financial collapse of 2008 crank start the economy back to life by lowering interest rates.  The lower interest rates, it is believed, would stimulate business investment, thereby reducing unemployment.   So the Reserve banks also stepped in with Quantitative Easing (QE). In other words, it also bought bonds with the intended aim of keeping interest rates low. But this policy also drove bond prices up and resulted in low yields.

The real fear now is that the policy adopted by the reserve bank, while it may have been successful in halting temporary a severe stock market crash, a bank run and a maybe even an economic depression, may also have inadvertently created a new bubble in equities, London property prices and the bond market.

Indeed, it is the latter, the bond market that is starting to look precarious. The tell-tale symptoms of “yield chasing”  by investors which has been aided and abetted by years of Quantitative Easing “funny money” and interest rates that have remained near zero and most recently even negative. The European Central Bank (ECB) will now be charging banks to keep their money in overnight deposits. Perhaps it is this perverse combination of yield chasing and funny money that is skewing investors’ perception of risk versus rewards. In Wall Street speak it has been described as “picking up nickels in front of a steamroller,” the risks are far outweighing the rewards. The glut of investor cash is being tossed into the bond market in the hope of sniffing out a decent return and bond investors have become oblivious to the risks.

Perhaps this is why investors have scrambled on board to buy Greek bonds. Surely the sight of investors celebrating the return of Greece to the bond market somehow underscores the problem.  Candidly, Greece’s economy remains a basket case, its economy lies in ruin after six years of depression, 27.5 percent of the workforce is unemployed, and the official figure may be even higher. Its youth are squandered with 58.3 youth unemployed. Its economy has shrunk by almost a quarter since the financial meltdown of 2008. Moreover Cyprus, the country that was hitting bank deposits and imposing capital controls just one year ago has most recently returned to the bond market.  Cyprus’s credit rating remains deep in junk territory and it is also plagued with high unemployment.

But flocking to high risk European sovereign bonds doesn’t truly reflect the improved state of Europe, but rather investors’ irrational exuberance fueled by cheap money and a ECB that now actually charges Banks for depositing their funds.

So perhaps this is why Bank of England Governor, Mark Carney, is proposing to do the reverse of the ECB and has surprised the markets by flagging up the prospect of rates rises from its historic low of 0.5 percent.  Even though it may seem premature to discuss the prospects of rate rises, while the British economy appears to show signs of clawing its way out of the longest recession in history the recovery is relatively fragile and unbalanced.  The economy still has excess capacity, inflation is low, growth in nominal wages is feeble and youth unemployment also remains stubbornly high at 35.9 percent among those aged 16-17 years.

It would appear that Mr. Carney is now more worried about financial stability than economic growth.  The BOE’s proposal to raise rates maybe intended to deflate the bond bubble and reduce leverage in the system. In a financial crisis liquidity vanishes and the price of risk goes through the roof. So a more leveraged system where credit is cheaply available is likely to face a greater disruption to the system when a crisis hits.

But when interest rates rise, bond prices fall. What happens when bond holders in volume decide to sell, who will buy this debt?  Perhaps this will be the catalyst to a bond bubble burst. But this would not only wipeout a chunk of life savings for those who invested in bonds via their pension schemes but it could also create another credit crunch, worse than that of 2008. This is maybe why Federal Reserve is considering imposing punitive exit fees on anyone trying to take their money out of bond funds to halt a run on the investments.

But a really question worth pondering over is what does Mr. Carney know that we don’t, why is he so prepared to sacrifice a fragile recovery for financial stability? “There may be trouble ahead, let’s face the music and dance.”