Central Banks Risk Bond Market Crash
The joke is that the maximum volume is usually 10, but this one goes a stage higher. “Turning it up to 11” has since become a way of talking about extremes, or reaching beyond what is normally possible.
I recite the origins of the term because, unlikely though it might seem, it recently cropped up in conversation with a senior Bank of England policymaker. In his view, monetary policy, not just in Britain, but pretty much all major advanced economies, was already at 11, and it was hard to see how it could go much further.
Interest rates had been slashed to virtually zero, and money markets had been flooded with near-free liquidity, yet still economies were refusing to respond. Monetary policy had reached the limits of its capacity to help, he seemed to suggest.
This is very possibly true, but that hasn’t stopped the pressure for even more. More to the point, central bankers seem prepared to accommodate it. I’ve been searching for the right metaphor, but I can think of none better than Spinal Tap. Central bankers around the world are about to go to amplification 12 or 13.
In the US, Ben Bernanke, chairman of the Federal Reserve, has announced that interest rates will be kept close to zero until unemployment falls below 6.5pc. By the by, he also seems to have raised the inflation target somewhat. To the extent that the Fed ever had one, it used to be 2pc. Well now it seems to be 2.5pc, for that’s the level which Mr Bernanke signalled might trigger some degree of tightening.
For Britain, Mark Carney, the incoming Governor of the Bank of England, has suggested targeting nominal GDP in preference to inflation, while even in inflation-averse Japan, the central bank looks set to further unleash the floodgates of monetary easing. With this weekend’s landslide victory by the Liberal Democrat Party (LDP) comes a government committed to doing whatever it takes to get Japan’s moribund economy going again.
This includes targeting 3pc inflation, a hitherto completely taboo concept for Japan. The second coming of Shinzo Abe also promises a renewed drive to weaken the yen with massive purchases of overseas assets, and despite already mountainous public indebtedness, another public spending binge. This is what Japan has voted for. Even Mrs Watanabe, the thrifty Japanese housewife of legend, seems to have had enough of constantly falling prices and relative economic decline.
In any case, all these developments suggest acceptance of higher rates of inflation as a price worth paying for getting advanced economies out of their post-financial crisis slump. You thought the central bank printing presses were already at maximum capacity. Well it appears that we ain’t seen nothing yet.
The only holdout in this latest push for monetary expansion, regardless of the consequences, is the European Central Bank, always the laggard in these matters. We’ll see how long the ECB is prepared to play holier than thou. With nil growth in prospect for at least the next year, not that long, is my guess.
For the purposes of this article, I’m not going to get too much into the moralistic rights and wrongs of this approach, suffice to point out the injustice of it all to those who sat out the dance, behaved responsibly during the boom, and built up a nest-egg of savings.
Those savings are already being decimated by a combination of low interest rates and elevated inflation, and are now threatened with even greater damage. Money printing is good for debtors, for it inflates away the value of their obligations, but it’s disastrous for savers, who see their capital steadily eroded. The prudent are punished while the profligate are rewarded.
But what of the wider, macro-economic implications? If this flood of central bank money works as it is supposed to, then it should eventually induce a bit more spending in advanced economies and therefore a return to growth.
Once this starts to happen, then, according to the textbooks, long bond yields will begin to rise. Equity prices already point to something of a cyclical recovery at some stage next year, so investors are to some extent already betting on the therapy working.
Bond yields, on the other hand, remain close to historic lows. There’s been a little bit of an uptick in the past couple of months, but nothing of any great significance. Having traded at 4.5pc to 5pc in the years running up to the crisis, yields on 10-year gilts remain firmly stuck at historic lows of less than 2pc. Equities and bonds point in different directions.
It’s a brave man who calls an end to the long bull market in government bonds, and a very rich one, if he gets it right. The Japanese bond market is littered with the bodies of those have erroneously bet on such a change.
For years, it has looked as if J-bonds were riding for a terrible fall. How could it be otherwise with government borrowing at 200pc of GDP? But it hasn’t happened. Instead, the Japanese economy has carried on deflating, making J-bonds the only rational choice for domestic investors.
What is more, central banks risk a calamitous unwind in their economies if they move too fast. There is a paradox here. Central banks won’t know that the therapy is working until long bond yields begin to rise to reflect higher economic activity.
Yet by triggering such a reaction, they threaten to undermine the very recovery they are hoping to bring about. Many advanced economies are still too heavily indebted to be able to withstand a significant rise in interest rates beyond present, depressed levels. With public debt either approaching or already at 100pc of GDP, the danger of fiscal crisis is a real one for both the UK and the US.
In any case, inducing a rather higher rate of inflation implies a crushing degree of “financial repression”. In essence, the central bank has to operate a negative real rate of interest in order to trigger a revival of demand. For a while at least, both long and short-term rates of interest have to be held significantly below the rate of inflation.
Turning up the monetary dial to 12 or 13 therefore implies not an early disruption in markets but a continuation of these very low bond yields for quite a bit longer yet. We’ve been here before. Something similar was operated by the US during and immediately after the Second World War, with yields on 10-year Treasuries held at 2pc.
Ultimately, this proved very bad for creditors, who lost their shirts in the subsequent bear market in bonds, but good for taxpayers, who saw the national debt eroded away steadily by growth and inflation, so much so that Treasuries became known as “certificates of confiscation”.
Is the same thing about to happen again? Eventually, yes, but if I could tell you exactly when, to repeat the old cliché, I wouldn’t be sitting here writing about it.