Markets, of course, are simply mechanisms for measuring people’s emotions. And prior to yesterday afternoon’s murder of Labour MP Jo Cox, markets already looked extreme and stretched. Then they snapped.
As an example, take the fact that the entire Swiss yield curve – bonds of all durations, from short-term to 30-year – was negative. That’s right. The yield on a 30-year Swiss government bond went negative. That reflects extreme anxiety and risk aversion – a panicked flight to safety among institutional investors, which was also reflected in the negative yield on 10-year German bunds and the lowest-ever yields for 10-year gilts.
It might be prudent if you described it as risk aversion, in the same way that locking yourself in the basement during a tornado is prudent. But you know we’ve reached an unusual point in economic and financial history when perfectly rational behaviour – the behaviour of financial self-preservation – leads you to accepting a small destruction of your wealth to avoid a larger one.
What exactly do I mean?
Long-term bonds are more sensitive to interest rate rises than short-term bonds. I wrote to you about this earlier in the week. But if you missed it, let me refresh your memory. It gets to the heart of why having long-term bonds (20-, 30-, 50- and even 100-year maturities) with such low yields is so dangerous. First, check out the curve below.
A yield curve describes how a bond market normally works. The shorter the maturity of the bond, the lower the yield. The yield is lower because as an investor, your risk is lower (at least in theory). By “risk” I mean the risk that you won’t get your money back, or that inflation will lower the real value of your money when you’re repaid as the bond matures.
The key element is time. The shorter the time period of your loan to the government – and that’s what a bond is, a loan to the government – the less likely interest rates are to rocket up quickly. It could happen. But the risk is low. That’s important because, as you know, bond prices move inversely to bond yields. Or, in plainer terms, rapidly rising interest rates mean falling bond prices.
If you’re investing in short-term government bonds, you may not get a high yield. In fact, these days, you’ll get next to nothing. Or worse, you’ll get a negative yield. But you are likely to get your money back, or most of it. Because your time horizon is short, your risk is relatively low.
That’s not the case for longer-term bonds
And again the issue is time. The more time passes, the less we know. Or, in terms of the future, the longer-term your forecasts are about interest rates, the less reliable they’re going to be.
It doesn’t have anything to do with your intellect or the quality of your knowledge. It’s just a knowledge problem in general, and one we’d all do well to remember: no one knows what the future brings. No one.
Long-term bond investors are compensated, usually, for this ignorance of the future with higher interest rates. If you’re going to lend your money to the government for a long time, tie up your capital, and put it at risk to rising interest rates, the government will pay you a higher yield for your risk. That’s why a normal yield curve rises over time.
A yield curve where all bonds of all maturities yield less than zero is not a normal yield curve. It’s not a yield curve at all. It’s a yield flat line. It’s a dead market. But in terms of risk, uncertainty, and prices, what is the flat yield curve really telling you?
If you’re buying a long-term government bond at a low interest rate, you’re not getting compensated for the uncertainty about future interest rates.
Quite the contrary, in fact
You’re taking on extraordinary risk should interest rates rise. And when interest rates are at all-time lows, well doesn’t that seem like the point of maximum risk about future yields? Can they go anywhere but up from here?
The answer, right now, is that they can go negative. But again, think about it in risk terms and you’ll realise why the status quo can’t last. Your capital is at risk with a long-term bond because any future long-term bond with a higher yield (or even a slightly shorter maturity) will become more valuable. By “become more valuable” I mean the price of the new higher-yielding bond will go up and the price of the lower-yielding bond will go down.
That’s just competition and prices at work. Make it an issue of future bond supply and it becomes even easier to understand. Imagine interest rates going up very slowly over the next ten years. Britain’s government – which continues to run deficits – issues debt to finance its spending habit. That debt is issued at the prevailing (and steadily higher) interest rates.
The new higher-yield debt will be more attractive and thus goes up in price, then the older higher-yield debt. Why? Because given relatively equal maturities, one pays you more for your future risk than the other. The one that pays you more risk ought to be more valuable and thus go up in price.
The systemic risk of low bond yields
I hope you’re still with me on this descent into the bond market rabbit hole. But it really is an important point. When so much money is tied up in long-maturity government bonds at low yields, that money is massively at risk if and when you get a rise in interest rates. That rise can be by design. Or it can be sudden, driven by external events that nobody saw coming.
Let me guess what you may be thinking: “How can interest rates rise if central bankers don’t raise them?”
It’s a good question. But just remember, central banks only target the short end of the yield curve with their policy rates. They aim to influence the price of short-term credit through their open market operations.
They don’t control the long end of the curve and they haven’t tried to, at least not yet. The market controls long-term rates. That is, long-term interest rates are determined by what level of compensation investors demand for unknown long-term risks.
And that’s why we have a problem today
Central bank bond buying – and the general climate of fear about the endgame of this whole monetary experiment – has driven long-term yields down to record lows. From here they can go marginally lower. Or, they can stay low for a long period of deflation and stagnation (in which case bonds make perfect sense).
Or they can go up higher and faster than anyone currently imagines.
It’s the last scenario that worries me the most. It’s exactly what usually happens… when money dies. When people lose confidence in government issued money, when it comes apparent that huge government debts will never be paid, or can only be paid with an inflated currency, then the market’s perception of long-term risk changes too.
Prices follow and rise. Inflation – once thought dead and buried – is off and running. The whole system is put at risk.
Category: Central Banks