Bonds bubble over. For now…

In our September magazine issue, we wrote about how sovereign bond prices were massively inflated and how risky it could be to one’s wealth to continue this buying frenzy (see here – http://issuu.com/spreadbetmagazine/docs/spreadbet-magazine-v8_generic Page 58).

Bubbles form because people buy frenetically without looking at the real value that an asset carries. When a 10-year Gilt yields 1.60% with inflation around 3% and when investors are actually willing to pay the German government to hold a 2 year note, something must be plainly wrong. But in markets, the “lunatics can continue to run the asylum” for far longer than many think, particularly when there is global central bank money printing purely to act as the backstop buyer of those bonds…

Tech crash all over again

Back on the eve of the new millennium, investors collectively pursued the bubble in tech stocks, buying shares with forward P/E ratios that were often higher than 100. As with tech stocks, one day the bubble will burst in bonds and when it does it will move violently catching the masses and entrenched conventional widsom off guard. By its nature we cannot predict when that day will come and what the catalyst will be, but we can position for it.

Earlier this year, government bond yields hit record lows in the US and in the UK and investors were actually paying to hold debt in places like German and Switzerland. It seems investors ran blithely into the “perceived” safety of bonds given the concern over global growth but more particularly the European debt crisis.

The Great Financial Crisis epicentre in 2008, created a big liquidity problem around the world with banks running short of funds and so requiring a prolonged period of cheap money cash injections in order to re-liquify whilst the deleveraging process got underway. The central banks rode to their rescue and interest rates, which at the end of 2006 were 5.25%, 5.00%, and 3.00% for the FED, BOE, and ECB respectively, quickly turned down to less than 1%. As interest rates were cut by central bankers, the appeal of government bonds increased and prices shot up while yields came down.

Bonds don’t compensate for inflation

Unfortunately for all those pension funds that need a minimum yield to make their annuity assumptions stack up, monetary policy didn’t end with interest rate cuts, the central banks then decided to then make massive asset purchases targeting treasuries, bonds and mortgage-backed securities. As a result, bond yields turned even lower to such an extent that a 10-year government bond yield in the US & UK would hardly compensate for inflation. All the time money printing occurs as a potential store for future inflation which will of course decimate the capital value of those bonds and the value of the income payments…

Even though there are cracking equity based opportunities as we have been pointing in our blogs (Japanese equities, mining stocks, Oil & Gas, and even China), investors are still seemingly looking for the safety of government bonds, seeking for debt from the UK, US, Germany, Scandinavian countries, and Switzerland. Either that or collectively investors are expecting a global economic catastrophe at some point in the future – Euro break up, fiscal cliff not being resolved? Problem is the Vix index doesn’t spell the same expectation… This leads us to believe that the market is distorted by the unprecedented Government buying – predict when this stops and the world is yours!

Between our magazine article in late August and now, bond yields haven’t changed significantly. With Barack Obama renewing “Helicopter Ben’s” FED Chairman mandate, Ben Bernanke will certainly continue with the monetary easing policy for quite some time and so likely maintaining the pressure to the downside on yields down.

And so, while the global central banks continue to create an artificial demand for bonds, we doubt that global asset allocators will continue to follow them, certainly at current yields. Many fund managers are concerned with the income they get from Gilts and Treasuries. After discounting for inflation, they will probably end up losing money for their clients and they have to look for other assets. Pension funds are in the same boat. Retail investors have already begun to look for opportunities outside the fixed income market.

At some point the time will come when central banks will have to sell the assets they have been accumulating on their balance sheets. Guess what will happen to bond prices… As ever, it will be very painful for those left holding the baby – that means US the taxpayers as the central banks will be backstopped by their respective governments of course!