Rampant Bonds - Signs of Deflation or a Bubble ?

Government bonds have been the only place in town so far in 2010. Is the unexpected rally in bonds a sign that investors feel deflation has gained the upper hand - in which case buying the protection of capital that government bonds provide irrespective of the income available makes sense – or are we witnessing yet another asset bubble in the making ?
I find it useful to look at the performance of government bonds over a longer term perspective to see where we are in the cycle. The first chart I enclose is the US 10-year government bond yield since the late 1970s which offers a decent proxy for the performance of government bonds yields across the developed world over this timeline. The yield on the US 10-year bond declined continuously from a brief spike to near 16% in late 1981 to a low of just above 2% in 2008. The rally in bonds in 2010 has brought the US 10-year bond yield down to 2.6% and approaching the lows of 2008.

A declining bond yield reflects rising bond prices. By way of an example, let us assume that the yield on a 10-year government bond rises to 6% from 5%. Under this scenario, the price of the 10-year government bond will decline to offer the new investor the equivalent of a 6% per annum return over the remaining life of the bond. In practice, then, rising bond yields reflect falling bond prices and declining bond yields, as has been the case in the developed world since the early 1980s, reflect rising bond prices.

Inflation was gradually subdued in the early 1980s allowing both short term interest rates and long term bond yields to decline, and they declined for a period of twenty seven years despite frequent counter-trend rallies. The decline in bond yields since the early 1980s has been a true long term bull market.

The second chart or table summarises the real returns (i.e. after inflation) that investors in longer dated US and UK government bonds have obtained every decade since 1950 and, in aggregate, over this sixty-year period. Government bonds offer a guarantee of capital. As a consequence, and like cash deposits, they only have to provide investors with a modest return over and above inflation. The US 20-Year government bond provided a 2.1% compound per annum return over inflation over this sixty-year period. In the UK, the long term real return from bonds over the same timeline was somewhat lower at 1.3% per annum.

In both economies, negative real returns in the 1950s, 1960s and 1970s gave way to the super-sized positive returns in the 1980s, 1990s and 2000s. In fact, over the past 30 years, real bond returns after inflation in both the US and UK have been on average 5.9% - some three to four times the long term average respectively. The US 10-year bond currently yields 2.61%. Based the long term real return of 2.1%, then investors must be expecting US annual inflation to average only 0.5% over the long term from here.

And now back to the key issue – is there a bubble in bond valuations ? On the NO side there are some persuasive arguments led by economists such as Paul Krugman, economic Nobel prise winner. The emergence of Asia with cheaper goods and lower labour costs has been highly deflationary for the developed world. It addition, its the weak banking system and high levels of consumer debt which, following the global banking crisis, has driven up private savings, will likely act as a drag on growth for years to come. Against that backdrop, inflation is likely to remain muted even if fiscal spending stays high. On the YES side is the arguments that demand for bonds has been inflated by both the quantitative easing programmes of the central banks themselves and the near zero cost of short term money.

My own view, for what it is worth, is that I feel the mentality of the US and UK governments has always favoured growth and jobs over inflation and if we do not see a pick up in economic activity and employment levels authorities in these two countries are unlikely to hesitate to print money to escape the debt trap. With visible cracks in the Euro-zone, Germany’s resolve to such inflationary tactics could easily weaken. For these reasons, I believe bond yields at these levels represent bubble valuations. Of course, a bubble in bonds is not are as dangerous as a bubble in equity, property or other asset classes. As long as they hold the bond(s) to maturity, investors at least get their capital back even if they have lost some purchasing power.
 

Rory Gillen
Founder
27th August 2010

GillenMarkets (www.gillenmarkets.com)