It's time to sell government bonds
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Associate Editor
David Stevenson Jan 09, 2009
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After dotcom stocks, sub-prime mortgages, emerging markets and oil… are government bonds the next big 'bubble'?
Not quite as exciting as some of their predecessors, sovereign debt prices are still a key indicator of where the world economy's heading next. And anyone expecting bad economic news to keep driving prices for these 'safe havens' up - and yields down – will, as usual, be disappointed.
Meanwhile there's another threat looming on the horizon for government bond bulls – a potential 'buyers' strike'…
GDP is expected to keep decreasing in 2009
First, thanks are due to Société Générale's James Montier for a long-term chart of the yield on US ten-year Treasury notes – these are American government debt securities that mature after ten years and are the most often-used benchmark for the 'long-term' cost of global capital.
Going back to 1798, it shows that the current ten-year yield is 2.4%. This is right at the bottom end of the 200+ year range. Indeed the trend has been downward for the last 27 years.
Looking back, since the eighteenth century, the average ten-year yield has usually sat just above 4.5%. This seems reasonable as it reflects the rate of consumer price rises plus the economic growth rate.
But 2.4%? That flags stagnation, says Capital Economics: "We expect GDP to continue shrinking throughout 2009, with annual inflation going negative".
US bond yields point to years of deflation
Though, as Montier points out, all-time low yields aren't necessarily a 'sell'. He cites Japan, where ten-year bonds fell to sub-0.5% in 2003 as the economy tanked, and are still only 1.3%. But he reckons current US Treasury yields "imply inflation will be around 0% over the next ten years", which suggests the States "will follow the Japanese path into grinding deflation".
Will that happen? "I haven't a clue", he says, "and nor has anyone else". But what's very clear is that "bonds simply don't offer any value".
So even if you're in the economic gloom-and-doom camp, the upside for government bonds is starting to look more than a little limited. 'Risk averse' investors have piled into the likes of US sovereign debt simply because virtually everything else looked far too dodgy. So US bonds have got more than a bit frothy.
"Eight weeks ago, Treasuries moved into the 'blow off' stage", says DailyWealth's Tom Dyson, "I believe the bubble's now popped, and it's time to start betting on a rise in Treasury bond rates". Despite a relentless flow of horrible economic news, like soaring jobless claims, plunging car sales, tumbling house prices, the lowest level of manufacturing activity since 1980 and the worst set of new manufacturing orders since 1948, US bond yields have flipped higher.
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Bonds have garbage fundamentals
Apart from the value issue, there's another catch. American bonds "have garbage fundamentals", says Dyson, "the US Treasury's about to flood the market with supply. As well as increasing the size of its bond auctions, it has also upped the frequency from eight times a year to 12".
We're talking vast numbers here, as not just the Americans need to raise loads of cash. The US alone is expected to issue $2trn (£1.3trn) of debt this year, says the Telegraph's Ambrose Evans-Pritchard, and the Europeans aren't far behind. "Italy alone must tap the markets for €200bn as it rolls over its huge stock of public debt". Further, ratings agency Fitch has said that Ireland, Greece, Holland and France all face big auction programmes.
And as for gilts, don't ask. Fitch says Britain has a "terrible underlying fiscal picture, by far the worst" of the mainstream countries. That adds up to £145bn of debt – 10% of GDP – just in 2009.
"There are fears the next crisis in the global financial system could to be a rebellion by bond vigilantes, already worried by bubble talk", says Evans-Pritchard, "this would push up rates used to fixed mortgages and corporate bond deals".
This week, even Germany only managed to sell just two-thirds of a €6bn sale of ten-year Bunds, whose yield has plunged to long-term lows of some 3%. "It's very poor", says Monument Securities' Marc Ostwald, "I can't remember the Bundesbank ever being left with a third of the bonds". Nor is confidence likely to be much improved by yesterday's news that the German government is being forced to shell out another €10bn on a second Commerzbank bailout in less than three months.
Meanwhile, the buying power for government bonds could plummet anyway, as the global recession means fewer exports, and so less available cash, from traditionally the largest bond customers – the Japanese and the Chinese.
In short, it's starting to look like a government bond 'buyers strike' could be about to hit the market - the recipe for a major rise in yields and so a plunge in prices. "The bear market in government bonds starts here", says The Independent's Jeremy Warner.
If you own government bonds now, it sounds like time to head for the exit. If you don't, wait…
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