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The Bond Bubble

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Observer

Sorry if its already been posted.

There is much to be terrified about in today's global economy. The eurozone's death dance, China's slowdown and America's inability to create jobs are enough to make the most upbeat investors gloomy. But even these problems pale in comparison with the biggest threat, one with implications so hideous that financiers are reluctant to talk about it even now. The truth is that the economies of rich countries, including the UK, are being kept alive by another and astonishingly under-reported bull market — in government debt. This is the bond bubble; and when it bursts, as it surely will, the result will be a recession far deeper than the crash from which we are trying to recover.

This danger is ignored for a very understandable reason: government bonds are so boring that most people pay them no attention. Yet they fulfil a vital role, crucial to Britain's nascent economic recovery. Bonds are, in effect, the IOU notes issued by debt-hungry governments. America, unsurprisingly, is the biggest issuer. The bond market is the pipeline of debt, flowing into the British economy and setting the price at which banks lend to mortgage holders and small businesses, as well as the cost of borrowing for the large multinationals that employ so many Britons. Bonds have also become the drug to which the political establishment is now addicted.

These bonds have become dangerously cheap. A new record was set this week, when George Osborne's Treasury was able to borrow at an astonishing 2.2 per cent a year over a ten-year period. The German government can do so at 1.8 per cent a year, and America at 2 per cent. Crucially, in many cases, the interest rate is less than the expected inflation rate. So the 'real terms' interest rate at which governments borrow is actually negative. Lending anyone money at zero interest is weird enough. But the bond bubble now means that UK and American governments can be loaned money — and, in effect, be paid for the privilege.

This is crazy. It shows that the bond markets are well and truly in major bubble territory, their valuations as absurd as the rocketing subprime properties of yore. And, just like last time, hardly anyone is sounding the alarm. The bond bubble means that banks can also borrow at very low rates — and pass it on, allowing us to carry on taking out cheap mortgages. Fatally, we have come to think of 3 per cent mortgages as the new normal. Companies, home-owners, storecard holders — everyone is being lulled into a false sense of security. No one is prepared for when the bond bubble bursts and interest rates shoot back to their norm.

So why has debt become so cheap? There are three reasons. The first is Alan Greenspan, former chairman of the US Federal Reserve, who tried to recover from the post-9/11 slowdown by lowering interest rates — a hubristic decision which imagined that cheap debt would generate permanent and real growth. These new, ultra-low American base rates soon spilt over to government bonds, fuelling the bubble.

The second is the rise of the services sector. As developed economies moved away from being reliant on expensive factories, they didn't have to invest so much in new machines. More money was left over to invest in other things, such as bonds, which pushed down the cost of borrowing.

The third and most dramatic cause of the bond bubble is the savings glut in the emerging markets. Developing countries have been saving their pennies — and lending them to the debt-addicted countries. Thrift, which used to be a virtue of the West, has now gone east. The sums involved are staggering. In 1995, foreign exchange reserves held by the world's central banks (mainly in emerging countries) stood at about $1.4 trillion. It is now $9.7 trillion, a third of it Chinese, and with an additional $4.7 trillion in sovereign wealth funds held by cash-rich countries like Norway and Qatar. In total, a $14.4 trillion piggy bank — a lump of cash so large that it is distorting the world economy.

All this money can't be kept as bank notes under Chinese mattresses. It is usually invested, and western bonds are supposed to be the safest investment there is. So an avalanche of cash cascades from East to West. The sheer volume of this cash inflated the bond bubble, which means western governments can get away with lending at ridiculously low interest rates. For the finance minister, this means cash to fund huge deficits. For the consumer, this means a 3.2 per cent fixed rate mortgage. And for the debt addicts everywhere, this means as much cheap dope as they can lay their hands on.

As economic curses go, cheap debt may not seem to the cruellest. But the bond bubble is dangerous, because it encourages bad behaviour. It creates the impression that anyone can borrow anything — and get away with it. George Osborne argues that Britain's AAA credit rating is crucial, and he's right. But when Standard & Poor's downgraded America's to AA+, there was no punishment. Instead, there was so much demand for American bonds that the real-terms interest on the bonds went below zero. Barack Obama was 'punished' by investors saying they'd pay to borrow from his government.

The verdict of the Keynesians was instantaneous. The economist Paul Krugman was jubilant: 'What the market is saying — almost shouting — is "we're not worried about the deficit! We're worried about the weak economy!"' Certainly, if investors see no opportunities anywhere else in the economy, they will accept ultra-low rates on government debt. But the bond bubble distorts what the market is saying, sending out a false message. The market is by no means relaxed about the deficit. Asian economies may hate this, as much as America loves it. But the gargantuan pile of cash has to go somewhere and bonds are, for now, the least bad choice.

China spelled out its dilemma after America was downgraded. The Chinese state news agency, Xinhua, said the USA should cure its 'addiction to debts' — without seeming to notice the obvious implication that Beijing is the drug pusher. But for all China's criticisms of America's profligacy, it has no choice. America's debt market is the only one big enough to absorb China's savings pile. Such an appetite for bonds not only allows America and Britain to keep on borrowing, but actively encourages it.

Britain needs this debt, and badly. For all George Osborne's talk of austerity, the Chancellor plans to borrow more over this parliament than Labour did in 13 years. Certainly, Labour's published plan would have increased debt by 59 per cent, against the Tories' 51 per cent. Osborne's plan — to stop increasing debt in seven years — may not be much different from that of Alistair Darling. But it's solid and more credible than many of the plans offered on the Continent. This keeps Britain inside the deceptive warmth of the bond bubble, with cheap debt for all. But with a deficit which remains among the worst in Europe (we have the most indebted households in the G7) Britain remains worryingly vulnerable.

The irony is that it was the debt bubble, in its earlier years, that helped cause the financial crisis from which we're now trying to recover. As the cost of borrowing fell, starting in the early 1990s, everyone started to lose their heads. Nobody ever discusses this because it is easier to criticise greedy bankers; but much of the excessive leverage, the maxed-out credit cards, the house price bubble from Dallas to Dubai, the over-exuberance and the massive misallocation of capital into overvalued property can be laid at the door of the bond markets. And these bond markets were, of course, themselves hugely distorted by the rate-cutting central bankers Alan Greenspan and Sir Mervyn King.

So the bond bubble not only helped cause the boom and subsequent crash. It then helped western governments deal with their hangover by serving another round of debt tequila. An economist from Mars, landing today, would find it extraordinary that most western countries are responding to the debt crisis by doubling their national debt. And if this pipeline of cheap debt dries up, what then?

Slowly, across Europe, we are beginning to find out. The debt bubble is bursting in some countries but not others. Italy, for example, is now having to offer 5.5 per cent interest on its IOU notes — a rise which is causing agony for its government and people. Greek bond markets have gone off the scale, with the market demanding more than 170 per cent to take on its three-year bond. Even the cash-rich Chinese fear that Greece is going bust. This panic over the dodgy European countries only serves to increase demand for bonds in Britain, lowering our debt costs further.

The thing about bubbles is that you never know when they will burst. But already there are signs of strain. The governor of China's central bank recently declared that its reserves 'exceed reasonable requirements' — a nod to the fact that Brazil, China, Russia and India are facing pressure to spend the cash on development at home. As the emerging markets grow richer, they will spend far more on machinery and roads — and deposit less in their piggy banks. If the $14 trillion worldwide piggy bank starts to be emptied, the bond bubble will deflate, pushing up interest rates around the world. The populations of emerging countries are also getting older. This means they will dip into pension pots, thus also reducing the amount of money available to go into bond markets.

If debt starts to be priced at normal rates, the adjustment will be agonising — not least for Osborne's government. How many Brits would be comfortable if their mortgage interest rates went back to 6 per cent, which was normal, even cheap, for so much of our recent history? Or 10 per cent? Trillions of pounds' worth of pension and insurance money is invested in bonds, so when they crash it will destroy wealth on a massive scale. Stock markets will fall, in some cases severely, while the great property boom will give way to a crash — as the cost of mortgages climbs permanently higher.

After the last crash, the Queen visited the London School of Economics and asked a killer question: 'Why did no one see it coming?' The answer is the same reason that no one now talks about the bond bubble: mankind is hubristic. There is a huge willingness to believe that artificial prosperity, caused by excessively cheap credit, is actually real. The bubble may hang over Britain for many more months, perhaps even years. But it is madness to think it will last forever. Sooner or later, the party will be permanently and ignominiously shut down, the real hangover will begin. And this time, the only cure will be belt-tightening, sweat and hard work.

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Missing the point completely.

Lower bond prices will reflect normalisation of global imbalances.

So if/when China succeeds in reversing its mercantilist policy, increases domestic demand and so on, the trade deficit with the US/West will correspondingly fall, reducing their demand for US bonds.

This will in turn improve the US trade deficit, reducing the pressure to issue govt. debt, allowing interest rates to normalise alongside an increase in employment and probably manufacturing in the US/West.

This will all be a good thing. In the UK it will coincide with a much improved budget deficit and revived domestic growth.

Nobody had much of a problem paying 5.5% on their mortgage in 2005/6. They won't in the future.

The only thing which is bizarre about these sort of articles is why they're not viewed as positive rather than negative.

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Bonds have been on a 30 year bull run from a 15% yield in 1981 to close to 2% now.

All secular bull runs of this magnitude eventually end. We are now in the blow off stage for bond prices before they collapse.

There is now tallk of a 'new paradigm' for bonds. 'Yields willl stay maga low for ages', bond inflows are reminiscent of equity inflows in 2000, etc.

Classic market top.

30 year secular regression back to high yields facing the West very soon.

Edited by ringledman

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Bond bubble is just another view on national debt. If slashing the (UK) deficit were reality rather than just rhetoric, the (UK) bond bubble would go away. Substitute other countries as appropriate.

The imbalance we have now is inflation. A secular trend of falling bond yields would've been entirely sustainable if it coincided with similar trends in inflation, debt levels, and interest rates, as was the case (here, at least) until about 2000.

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Missing the point completely.

Lower bond prices will reflect normalisation of global imbalances.

So if/when China succeeds in reversing its mercantilist policy, increases domestic demand and so on, the trade deficit with the US/West will correspondingly fall, reducing their demand for US bonds.

This will in turn improve the US trade deficit, reducing the pressure to issue govt. debt, allowing interest rates to normalise alongside an increase in employment and probably manufacturing in the US/West.

This will all be a good thing. In the UK it will coincide with a much improved budget deficit and revived domestic growth.

Nobody had much of a problem paying 5.5% on their mortgage in 2005/6. They won't in the future.

The only thing which is bizarre about these sort of articles is why they're not viewed as positive rather than negative.

I'm not sure the article entirely misses the point. It does talk about the underlying causes.

"Rebalancing" is perfectly desirable, however you can't ignore the likelihood of it not being an instantaneous process. Before domestic manufacturing (and jobs) will step in, imports will get crushingly expensive with no easy substitutes and with a workforce ill-equipped to suddenly tool up and start producing. In fact, the point of the article was precisely that this period of cheap money has led to bad behaviour/malinvestments.

And there is little evidence so far that China et al are converting to good little consumers in a hurry.

Then we can factor in commodity demand if China starts directly its production to internal consumers...

Edited by mirage

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Bond bubble is just another view on national debt. If slashing the (UK) deficit were reality rather than just rhetoric, the (UK) bond bubble would go away.

No it wouldn't. China and the US would set yields and Gilts would be almost as low (if not lower than they are now, because of reduced supply). It would be over if the West stopped deficit spending (privately and publicly) and thus crashed Asian exports.

The imbalance we have now is inflation. A secular trend of falling bond yields would've been entirely sustainable if it coincided with similar trends in inflation, debt levels, and interest rates, as was the case (here, at least) until about 2000.

Not sure what you mean by this. In that the bond bull corresponds to a massive imbalance between producer and consumer economies I'm not sure how it is sustainable.

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No it wouldn't. China and the US would set yields and Gilts would be almost as low (if not lower than they are now, because of reduced supply). It would be over if the West stopped deficit spending (privately and publicly) and thus crashed Asian exports.

No contradiction there. Without the deficit spending, the debt wouldn't have built up from its low point around 2000.

Not sure what you mean by this. In that the bond bull corresponds to a massive imbalance between producer and consumer economies I'm not sure how it is sustainable.

Re-read what you're replying to! Low bond yields don't imply a bubble. It's the imbalance between low yields and high debt and inflation.

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high bond prices and low yields historically meant one thing - the expectation of low inflation, or even deflation.

the money you get back in several years time will be worth more than it is worth today.

could we be heading for deflation in the long term (as unlikely as it seems right now) following the japan route. that would be a nightmare for the government and home owners as the real value of debts increase.

japan saw a big spike in inflation after their credit bubble popped and the stock markets collapsed, and after about 2-3 years, inflation dropped down, asset prices fell, and have continued to fall for decades.

although at the moment it is due to a flight to safety, there maybe a bigger picture somehwere.

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japan saw a big spike in inflation after their credit bubble popped and the stock markets collapsed, and after about 2-3 years, inflation dropped down, asset prices fell, and have continued to fall for decades.

And when their bubble burst they were-

Creditor nation

Huge savings

Massive exporter

A currency that rose 100-200% against all other western nations

Sound like the fundamentals supporting the UK now?

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could we be heading for deflation in the long term (as unlikely as it seems right now) following the japan route.

We already have deflation as measured by money supply growth. The price rises we see today in the shops are the symptom of the inflation which occured earlier in the century in which £2.5 trillion was borrowed out of thin-air primarily to bid asset prices up (houses, pubs, care homes, private equity takeover targets, etc.). That money is still leaking out of those asset markets in to the wider economy. One day that will come to a stop. But how long will it take? And what will happen to the economy when it does?

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  • 284 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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