Who would have thought the US could get to a position where it could even think of getting investors to pay the government to lend it money.
Switzerland, with its financial rectitude and strong currency, yes. But profligate America and over $US14 trillion in debt and facing a 4th successive year with a budget deficit of more than a trillion dollars?
And yet the US Treasury has signalled that it will decide in may if to start issuing short dated notes at a premium and redeeming them at par: in effect a negative rate of interest where the difference between the premium issue price and the redemption price of par goes to the Government.
What makes this even more astounding is that last August Standard & Poor’s removed America’s AAA credit rating and cut it to AA2.
That was supposed to cost the US Government in higher borrowing costs, but instead, those fears about Europe and the Fed’s easings (supposedly another bearish point for the US), have helped drive bond yields even lower, so much so there have been some sales of short term notes at par (i.e. zero interest rates).
And America is not alone. German bunds, UK gilts and government bonds in Japan and Australia have fallen sharply in the past few months: Australia’s is at a 61 year low!
It’s no wonder AMP Global Investors chief economist,Dr Shane Oliver asks today, are bonds the new bubble?
Outside of the troubled countries in Europe, government bond yields in developed countries have fallen to generational and in some cases record lows.
Reflecting the capital gains that are generated when bond yields fall, returns from bonds have been very strong.
Over the last year global bonds returned 11.1% and Australian bonds returned 11.4%.
Over the last two years they have returned 10% per annum and 8.7% pa respectively.
With such strong returns it is worth asking whether they are in a bubble.
Our answer is no, but they could certainly be considered poor value and there are much better return opportunities elsewhere.
Generational lows
Despite seeing their sovereign rating downgraded from AAA last year, US 10 year bond yields have fallen to their lowest level on record (based on data dating back to the 1850s).
Australian bond yields are at their lowest level since 1951.
Bond yields in the UK, Japan and Germany are also running around generational lows, if not record lows.
What has driven bond yields so low?
The sharp decline in bond yields from the early 1980s can be largely explained by the shift from a high inflation to a low inflation world.
The more recent fall to extreme lows reflects a combination of factors, flowing from the Global Financial Crisis and its aftermath.
First, sub-par economic growth and benign inflation have further lowered equilibrium levels for bond yields.
Second, and related to this, market expectations for short term interest rates have been continuously revised down over the last few years.
Several central banks have been cutting interest rates again since late last year (e.g., the ECB, the RBA and central banks in emerging countries) while the US Federal Reserve, the Bank of England and the Bank of Japan have left interest rates near zero.
Furthermore the Fed has indicated that rates are likely to stay near zero at least out to late 2014, after previously indicating out to mid 2013.
The historical experience tells us that the longer short term rates stay low, the more likely it is that long term bond yields will converge on them as expectations of future short term rates are revised down.
This is exactly what has happened in Japan over the last two decades, particularly during the 1996-98 period.
The US, UK and Germany appear to be going through something similar.
Third, the US Federal Reserve and the Bank of England have been actively buying government bonds as part of their quantitative easing programs, which are designed to keep private sector borrowing rates as low as possible and encourage banks to lend.
This, and the expectation of more to come following recent comments from the US Federal Reserve, has had the effect of keeping bond yields lower than might otherwise have been the case.
Fourth, the US Federal Reserve introduced “Operation Twist” which involved selling short term bonds and buying long term bonds in September last year in order to further keep down long term bond yields and hence private sector borrowing costs.
Finally, safe haven demand for bonds from investors has been boosted in response to the worries last year about another global economic downturn, partly resulting from the intensification of the debt crisis in peripheral European countries.
In this regard it’s worth noting that sovereign bonds in perceived core countries have been the best safe haven through recent bouts of share market turmoil. As such they have been in strong demand
