Bond bubble could see the sky-fall

In 2008 a systemic collapse of the global financial system was narrowly avoided. However the bursting of the bubble in government and corporate bonds could set off a chain of events that brings us right back to the brink, and possibly beyond.

The disease might be worse than the cure

In 2008 a total collapse of the global financial system was narrowly avoided due to coordinated central bank money creation on an unprecedented scale. The collapse was caused by the bursting of the global credit bubble which had been building for around three decades. When the bubble burst, as all bubbles eventually do, the western world was facing a 1930’s-style deflationary depression.

The credit bubble had grown so large that allowing the banks, mortgage lenders and other financial firms that created it to pay the price for their reckless practices would have caused economic Armageddon. As a result governments instructed their central banks to buy up huge swathes of so-called “toxic” assets from these institutions, transferring the liabilities on to taxpayers. In essence governments had turned a banking crisis into a sovereign debt crisis.

Since 2008 governments have continued to act as the “lender of last resort” rapidly expanding their balance sheets in ever more desperate attempts to prevent another Great Depression. Today, the debts of nations such as the US and UK are so large that these governments are unable to finance themselves via the bond markets alone. Instead they instruct their central banks to print new money and buy the debt.

The Bank of England is buying around 50% of all the new bonds issued by Her Majesty’s Treasury, and the Federal Reserve is buying around 75% of the debt issued by the US Treasury.

This monetization of the debt has created the illusion that all is well, however nothing could be further from the truth.

In a normal market, the price of bonds reflects the rate of inflation. However with central banks intervening to buy bonds, the yields (interest rates) on government bonds have been pushed down to historic levels. In the summer of 2012 for example, the yield on 10-year government bonds in the UK (gilts), fell to the lowest level for more than 300 years, while in the US they reached their lowest for more than 200 years.

A 20 year chart of 10-year US Treasury Note yields (Click on the chart for a larger version)

A 20 year chart of 10-year US Treasury Note yields (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Research conducted by Crestmont Research shows that the interest rate payable on 10-year government bonds should be around 1% above the rate of inflation. This ensures that holders of long-term government debt are receiving a positive real yield (not discounting the fact that the official inflation rate is understated).

According to the most recent report from the US Bureau of Labor Statistics (BLS), the CPI inflation rate is running at 1.76%, however the current yield on a 10-year US Treasury is 1.78%. The yield on a 10-year US Treasury is therefore 0.98% below where it would be in a normal market environment.

However, as Doug Short noted in a recent article, if this calculation is based on a better measure of inflation, i.e. the Big Mac Index, which is currently running at 3.1%, “then the interest rate [on 10-year Treasuries] would be 4.1%. Consequently, if 10-year government bonds were to increase from 1.7% to 4.1%, bond indices would decline by about 20%”.

Since the US bond market is so big, losses even close to these levels are likely to have serious implications for the entire financial system. According to the Securities Industry and Financial Markets Association (SIFMA), as of Q3 2012, total outstanding US bond market debt stood at $37.7 trillion, more than half the size of world GDP.

In his latest column Ambrose Evans-Pritchard, The Daily Telegraph’s International Business Editor, notes that a bubble has also formed in corporate debt, “that threatens heavy losses for investors once interest rates spike up again”. “Yields on 10-year US corporate bonds have fallen to the lowest levels in history as a result of central bank liquidity, halving from 4% to well under 2% since early 2011” he said.

In a new report released yesterday Fitch ratings agency warned that investors could cope with a gradual return to higher interest rates, but that a “sudden rise” would result in huge losses for life insurers, pension funds, and other fixed-income institutions.

“If interest rates were to revert rapidly to early-2011 levels, a typical BBB-rated US corporate bond could lose 15% of its market value, with longer duration bonds [30 year bonds] suffering a 26% loss,” it said, adding that, “As rates fall further, the risks and severity of a potential correction mount”.

The fallout from the bursting of the bubble in bonds could be devastating. Even a modest jump in yields would add significantly to the debt servicing costs of both governments and businesses, something which would jeopardize deficit reduction plans, and, in turn, credit ratings.

However the effects are likely to be felt far beyond the government and corporate debt markets. Record low rates are providing the UK property market with critical life-support, and low monthly mortgage payments are freeing up funds to be used elsewhere. A jump in borrowing costs would hit banks and other lenders forcing them to raise mortgage repayment costs, which in turn would burst Britain’s property price bubble.

The US property market is also venerable to a rise in long-term rates. There are already close to 1 million US homes that are at some stage of the foreclosure process, and US banks hold around $1.5 trillion worth of US mortgage securities.

The bottom line

There can be little doubt that a sharp rise in interest rates would prove devastating for those holding fixed income investments such as government and corporate bonds. However the fallout from the bursting of the bond market bubble could easily set off a chain of events that brings us right back to the brink of financial collapse, and possibly beyond.

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