Tuesday, 24 February 2015

Bond Bubble

I have noticed there has been more interest over the past few years regarding Government Bond Rates. In many countries they are at historic lows, all time lows even. Interest rates in many countries have gone negative, whereby the rate of inflation is now higher than the rate of return in the bond. Its gone even spookier than that now. A rate of return economists thought was impossible has now happened, that is interest rates on bonds have actually turned negative in some countries. In Switzerland a 10+ year bond can be bought to actually have a minus rate of return. This has never been seen before. I first mentioned the bond bubble six years ago and its worth revisiting as it applies equally to where we are now:
However with the new intention for expanding the money supply to "combat" deflation, QE is now monetising many of these bonds, in effect creating artificial buyers. Similar to the recent housing bubble, real demand was never there, it was just people flipping houses to one another with artificial cheap money as the driver. The market anticipates this new QE artificial demand, by lowing rates as there is less risk on default as more buyers have entered the market - seemingly increased demand, limited supply. This is where the real trouble begins, the point we find ourselves in now.... 
We are only in the early stages of the above. In theory, this could be stopped now with the Government abandoning QE, but I doubt it. Not with the huge deficits to come and the lack of Global Capital. The above describes the very process of how the Central Banks believe they can beat the market. However they can't, as the above details, they can only make it worse and the longer they try to 'beat' the market the worse they make the situation. In the event that things go to far they will destroy the currency, the lifeblood of the economy, thus impoverishing us all. Prices are there for a reason. Economists will tell you that when yields come down, that the Central Banks have saved us and proclaim that QE has worked. It can never work and is doomed to failure. The longer they try and hold the short term price down, the higher it will shoot up eventually and the longer it will stay there.
Its a measure of the mess we find ourselves in that rates continue going so low, to lows that we once thought impossible. This is a once in a lifetime super bubble, one that we will tell our Children and Grandchildren about. To an inquiring mind, how and why have rates gone so low and what format will the aftermath take?

A number of reasons exist why bonds have gone so low, the main one however is QE. Its no coincidence that since the ECBs announcement to an extension of the QE program that rates have gone to all new time lows. QE is distorting prices of bonds by creating artificial buyers. The increase in demand causes prices to rise (when bonds interest rates fall, they go up in value as any existing holders can sell theirs on for a increased profit as they locked in higher rates) just like in any market. 

So we have Governments buying bonds but that still doesn't explain private buyers. Well, by law a number of financial institutions have to buy bonds. For example due to regulations set by the Government pension funds for example have to allocate a portion of their funds in Certain Government securities, regardless of the rate of return. How about banks or other buyers who are not forced? We still can't explain why they would buy a bond that will erode in value over time. Like any bubble it works on the premise of buying an asset for the belief it can be sold to a bigger fool.

When people were buying technology stocks in the late 90's, where a company had no dividend, no assets - in fact in some cases barely a business case. Still such companies were on paper worth billions. People bought the stocks not for fundamentals but for the belief they could sell them for a higher price than they bought them for. A similar prognosis back then to now causes this phenomenon; cheap money. Like technology stocks of the late 90's or real estate of the 00's, bonds are the new bubble in town. And just like real estate and the Technology stocks they will go pop. Central banks have made sure of that and when they do you need to stay well away.

How long have we got? I'm sure rates will still go lower, to lows we don't think is possible. However when rates go into long term upward trend Governments (or institutions the Government forces to be buyers) will be the only buyers in town turning the greatest bond bull market in history to the worst bear market. Currencies will gyrate with wild fluctuations. Inflation will go hand in hand with this. Markets will act in ways we have never seen before. Central Banks will provide small glimpses of the illusion that they have control but you can not contain a market price, it always breaks out in some form of spontaneous nature. Stocks and Real Estate will offer no protection. These assets generally go to new all time lows in real terms in such an environment. Precious Metals will once again resume their bull market run, going into a mania phase. CNBC and the such will have feature programs and stories of people getting rich by holding such assets, which incidentally is sure to be the next bubble once the bond market goes up in flames. 

The bond bubble. It may mean nothing to you now. It may mean nothing over the next few years. But in the coming decade however it will mean everything. So long as there exists centralised monopolistic control over money there will be bubbles. Reading what those bubbles will be can be the tricky part but once you can read histories rhythmic patterns the future is for all to see. Then its just a case of taking the correct actions, sit back; relax and watch history unfold.