Jeremy Warner: Record issuance is bad news for bonds

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The Independent Online

Outlook A harbinger of things to come, or just an anomaly? To everyone's astonishment, the German government yesterday failed to raise the full €6bn it was looking for from an auction of 10-year bonds.

It's not the first time an auction of German bunds has fallen short, but it was pretty much unheard of before the credit crunch, and as the first big euro debt issuance of the year, it has put the fear of God into governments around the world as they seek to raise record amounts of money from debt markets to fund their anti-recessionary policies. If even Germany, source of possibly the safest form of government debt on the planet, is struggling, what hope for everyone else?

Government bonds were about the only asset class to enjoy a bull market last year, with interest rates plunging to record lows. But the present rush to replace fast-disappearing private debt with public debt promises to produce unprecedented levels of supply, including £145bn from our own Government this year alone.

Barack Obama, the US President-elect, has conceded this year's US budget deficit will break through the $1trillion mark for the first time, and was likely to get even bigger in subsequent years. Germany has announced a €50bn reflationary package, and so on.

All in all, more than $3trillion of sovereign debt is expected to be issued this year, more than three times as much as 2008. Can there really be the appetite for such mountainous quantities of the stuff? The bull market in bonds is driven primarily by fear of deflation. In a deflationary world, it doesn't matter how low the coupon gets, for as long as inflation is negative, the investor will still be getting a real rate of return.

Other, higher-risk asset classes will, meanwhile, struggle to maintain their value. One of the other chief characteristics of a deflationary environment is much higher rates of saving, which, as aggregate demand retreats, we are already seeing in large parts of the world.

More saving equals more money for government debt issuance. Until investors rediscover their appetite for risk, government bonds remain the only game in town. Yet if one investment bubble is always followed inevitably by another, government debt is very definitely taking over from where mortgages left off. Government bonds are showing classic bubble-like characteristics now, with yields having fallen precipitously over the past three months, supported by comments from the US Federal Reserve that it might create money to buy longer dated T-bonds to help keep deflation at bay.

In theory, then, there should be plenty of money around to absorb the eye-popping quantities of government debt awaiting auction, even if, bizarrely, governments themselves become some of the main buyers. Perhaps surprisingly, the British government had no difficulty in getting a £2bn tranche of 30-year gilts away yesterday. The issue was more than 1.7 times subscribed.

Nonetheless, the partial failure of the Germany bund auction suggests that there are limits. Assuming there is no long-term deflation, which is still the consensus view among economists, all this debt issuance is likely eventually to become highly inflationary. Indeed, it almost has to be if governments are ever going to get their finances back into any kind of shape following the present public spending binge.

Britain has never defaulted on its debt, but it has been particularly adept at doing the next worse thing, which is to inflate it all away. On any kind of long-term view, government bonds have thus turned out to be a pretty poor investment. With Britain's history of inflation, gilts have been particularly bad, even if this hasn't been quite so true in recent years.

All this helps to explain what happened to the German bond auction yesterday. January promises to be a heavy month for debt issuance, particularly in euroland. By tradition, Germany is always the first euro bond issue of the year. By shunning it, investors are sending out an important message – in the long term, they expect inflation to climb back up again and therefore won't buy longer-dated bonds on such low yields.

This is, in many respects, a good sign, for it suggests that markets don't expect deflation to take hold. They must be right about this, given the unprecedented quantity of policy action taken around the globe to ease the recession. The bear market in government bonds starts here.

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