Hamish McRae: Even bond bubbles can burst, and the cause might be quite unexpected

Click to follow

The policy of using interest rate cuts to pump up demand is being tested to destruction, for we have now reached a stage in the US where further interest rate cuts would have little more than symbolic effect. We cannot know whether this policy will work and just have to wait and see.

The policy of using interest rate cuts to pump up demand is being tested to destruction, for we have now reached a stage in the US where further interest rate cuts would have little more than symbolic effect. We cannot know whether this policy will work and just have to wait and see.

But all policies carry costs. The costs in this case include most obviously the dangers both of pushing down long-term interest rates as well as short-term to a level that may be unsustainable, and subsequently re-igniting inflationary pressures. In other words, the Federal Reserve may be creating a bond bubble similar to the equity bubble, and then creating conditions where that bond bubble will be popped.

Indeed there is already a bond bubble. Long-term yields have fallen to a level that can only be sustained if you believe that the world is going to experience a prolonged period of price stability, maybe deflation. The only way to justify five-year yields of just over 2 per cent (see first graph) would be if there were to be no inflation in the US over the next five years. Don Straszheim, the independent economic consultant out in California who correctly called the bottom of the US equity market last autumn, is now calling the top of the bond market. US bonds have risen further and faster than at any stage in the past 40 years, a phenomenon that, he believes, "looks a lot like the Nasdaq run-up of the late 1990s/early 2000. Dangerous."

He says that between February 2000 and now, the decline in five-year yields was from 6.76 per cent to 2.08 per cent, which was greater in percentage terms (68 per cent) than the 16.13 per cent to 6.55 per cent (59 per cent) drop from September 1981 to August 1986. Once people think the market is turning they are likely to stampede out of bonds, creating a bond crash similar to the equity crash.

Bond crashes have occurred before. The middle chart comes from another firm of independent economic consultants, the Bank Credit Analyst team in Montreal. It observed trends between May 1991 and April 1995 and looked at the downward movement of US 10-year bond yields and short-term rates. It then compared this period with the period between January 2001 and today.

As you can see, in the early 1990s short rates came down from 8 per cent to a little over 5 per cent only to climb back to 8 per cent again as short rates rose. Were the pattern to be repeated, it is plausible that 10-year yields will rise from their present level of below 3.5 per cent to over 5 per cent over an 18-month period. The BCA team points out that it was an ugly bear market in 1994 for US bonds and it must be borne in mind that there could very well be another ugly bear market in 2004.

This is especially dangerous as US investors hunting higher yields have plunged into bonds. The graph on the right comes from the Bank of England's new Financial Stability Review, out today. It shows how the flows into US bond funds have been running this year at a much higher level than during the past two.

It looks very much as though this will be another example of unsophisticated investors being lured into bonds as a "safe" investment, when the potential for capital losses is just as great as it is for investors in equities.

There, I suggest, is perhaps the most disturbing aspect of the whole bond boom. People are taught that bonds tend to produce a lower return but are less risky than equities. You hear people saying this on the radio; you see bond funds being marketed in this way. On a 30 or 40-year view that is absolutely correct. On a three or five-year view this must be wrong. There must be at least as large a possibility of 10-year bonds falling by, say, 25 per cent over the next 18 months as there is of shares falling by the same amount - I personally would think it larger.

I think that, despite my accepting deflation as a serious threat. Even if there are other instances of deflation over the next year or two, most probably in Germany and the Netherlands, that deflation is unlikely to be universal. And even if the US does experience a bout of falling prices, it is unlikely that deflation would take as deep a hold as it has in Japan. There will be huge amounts of government bonds being issued around the world and that will tend to push up yields. In any case at some stage in the next few months there will be a modest recovery in equity market sentiment and that will draw funds out of bonds. Finally, at some stage people will realise that the interest cycle is over and the next move in rates will be up. The threat to bonds is not so much a resurgence of inflation; it is simply that other investments will look better buys.

There is a further issue here. If this line of argument is right and there is a real danger of a bond crash, what then?

Well, the concern must surely be that it could actually have more far-reaching consequences than an equity crash. Investors in high-technology shares must have been aware to some extent that there were risks involved, so the crash should not have come as a total surprise. Investors in bonds do not have that same awareness, so the consequences could be more serious.

One remarkable aspect of the collapse in share prices is how little impact it has had on economic growth. Some countries experienced an initial recession and Germany is now experiencing a second leg to that. But, in general, the world economy has continued to grow right through the cycle and some countries, most notably the UK, have grown every single quarter right through the downswing.

One of the reasons financial market mayhem may have had so little effect on the real economy has been the bond market boom. A typical portfolio with one-third in bonds will not have entirely escaped the bear market. But gains on the bonds will to some extent have offset losses on equities.

It is not easy to think through all the consequences of a bond market crash. It would be bad for pension funds of course but that is a known issue. It would be bad for governments forced to borrow at higher rates but again that is an obvious problem. There may be other less obvious effects - for example the impact on some bank balance sheets - that need to be looked at, for our experience is always that problems come from places nobody is expecting them to come from. If we really are now seeing the turning point in the global bond markets, then expect ructions in the coming months.