Thursday, August 26, 2010

Analyzing the bond market surge

One of the defining characteristics of the bond markets in the last few months has been the steady and continuous decline in yields. Therefore, bond market yields have assumed center-stage in an intense debate about the impact of rising sovereign debts across developed economies.

Bond yields have been falling in the major economies of US...

... United Kingdom ...

... Japan...

... and Germany

However, even as these bond yields have been falling, those of the weaker peripheral PIIGS economies have been rising, as reflected in the widening spreads with the benchmark 10-year German Bunds.

Bond vigilantes argue that the burgeoning deficits mean that it is only a matter of time before inflation returns and interest rates rise, thereby driving up bond yields. However, there are others who argue that the high unemployment rates, dismal short and medium-term economic prospects, and reluctance of governments to undertake further fiscal expansion, means that deflation (and not inflation) is the greater danger. In the circumstances, they argue that declining bond yields are a natural market reaction.

A third point of view that is getting louder is the claim that a bond market bubble may be inflating. They argue that faced with uncertain economic prospects, deflationary expectations, and possible sovereign-debt crises, investors are abandoning equities and postponing investments, and fleeing to the relative safety and liquidity of bond markets.

As Paul Krugman has written, the bond bubble hypothesis looks suspect in an environment where everyone expects unemployment rates to remain high and inflation to remain low (or even negative) for a long time. This effectively means that short-term federal funds rates are most certain to remain at its zero-bound level for "and extended period of time", in turn ensuring much the same with longer-term rates. Further, all the common interest rate forecasting models point to rates remaining at the zero-bound for a very long time. Also, as Krugman argues, currently none of the major market players are gorging on leverage to inflate a bubble.

The rising sovereign debt-burdens too have been generating uncertainties in the financial markets about the dangers of sovereign debt-defaults. This too has generated a increased demand for safe and liquid assets among investors. As Ricardo Caballero has written, the sub-prime crisis has seriously disrupted the private supply of safe assets and the recent European crisis destroyed part of the public supply of safe assets, thereby leaving investors with few options but to invest in the few remaining perceived (atleast till now) safer assets. He writes, "Moreover, each of these crashes raised perceived uncertainty and hence the demand for safety, thus the quantity gap keeps growing, and the yield of the few remaining "safe" assets has to implode in order to restore equilibrium."

The rising bond prices now, especially when supply of government bonds has increased dramatically following the spurt in government borrowings to finance stimulus programs, only means that the demand for government bonds has been increasing much faster than the rapidly growing supply. Since the regular purchasers like China have been net sellers on the US government debt markets in recent weeks, most of the buyers of government bonds have been cash-rich domestic banks which have been using the huge amounts of money released by the monetary accommodation into purchasing government bonds. In other words, the money printed and released by the central banks is getting locked up within the financial markets itself without flowing into the real economy, thereby perpetuating a liquidity trap.

Finally, for the bond vigilantes, there is the remarkable decade-long experience of Japan with ultra-low interest rates and bond yields, despite the country's rising sea of debt, which has been hovering at nearly 200% of GDP for many years now. Japanese 10-year bond yields are ruling below 1% and has been on a continuously falling trend, and the 5-year CDS spreads are comparable to those of Germany.

But the sceptics may have grounds for concern since, irrespective of whether we call it a bubble or irrational exuberance, the fact remains that bond yields have deviated considerably from other benchmarks. Equity risk-premiums, the expected excess return of shares over government bonds, are at record highs in America, Germany, Japan and Britain.

The critical issue will be how the exit proceeds. How will the markets react at the first signs of deflationary expectations bottoming out and central banks look towards raising rates? How will the markets react to any central bank efforts to contain and emergent inflationary pressures by selling huge quantities of bonds to drain out the massive quantities of liquidity injected?

Given the fact that markets over-react in both directions, it is very much possible that the larger the decline in bond yields, greater and more violent could be the upward correction. Further, since it may be a few years before the first signs of recovery (in unemployment and inflation) appears, the bond market fundamentals may deviate even further before the return journey begins (though long-term bond yields cannot fall below 0%!).

If an indiscriminate and excessive market reaction then takes place, everyone would start blaming the current policies for having inflated the bond prices (Note that this illustrates how bubbles are often a post-event market reaction). The Economist points to the surge in ten-year government-bond yields from 0.5% to 1.5% in just three months in Japan in 2003 following expectations that deflation was fading off and fueled by casual remarks by the Bank of Japan.

In conclusion, all macroeconomic and market indicators appear to amply justify the declining trend in bond market yields, though the extent of declines may be somewhat debatable (ultimately, post-facto, if there is a bubble and it bursts with a violent surge in yields, then the extent of deviation will be held up as having signaled the bubble). However, the big challenge will be to manage (or more realistically, hope for) a smooth market turn-around once the deflation fears ease off and unemployment rate starts to fall. On the brighter side, given the prevailing economic environment it is hard to expect any recovery before 2012-13, thereby giving the bond markets more time to assess the fundamentals and return to normalcy. In other words, though the current market reaction is justifiable, it is to be hoped that the bond yields return to normal with a soft landing.

See an excellent Economist debate on the issue here - I am inclined towards Paul Seabright and Tyler Cowen's caution, purely due to the uncertainties associated with any exit.

Update 1 (30/8/2010)
Nick Rowe makes the interesting point that since bonds and money (the medium of exchange) are close substitutes (and more so now, at ultra-low rates), a bond bubble becomes a problem once it spills over into a bubble in money. He writes, "An excess demand for the medium of exchange is what causes, and is the only thing that can cause, a general glut of all goods. And that causes employment and output to fall, and both consumption and investment to fall."

From a general equilibrium perspective, he writes, "if we define the "fundamental" value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values."

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