Today's obvious mispricing of sovereign bonds is a bonanza for spending
politicians and allows over-leveraged banks to build up their capital. This
mispricing has gone so far that negative interest rates have become common:
in Denmark, where the central bank persists in holding the krona peg to a
weakening euro, it is reported that even some mortgage rates have gone
negative, and high quality corporate bonds such as a recent Nestlé euro bond
issue are also flirting with negative yields.
The most identifiable reason for this distortion of free markets is bank
regulation. Under the Basel 3 rules, a bank with sovereign debt on its
balance sheet is regarded by bank regulators as owning a risk-free asset.
Unsurprisingly, banks are encouraged by this to invest in sovereign debt
in preference to anything else. This leads to the self-fulfilling second
reason: falling yields. Central bank intervention in the bond markets through
quantitative easing and commercial bank buying leads to higher bond prices,
which in turn give the banks enormous profits. It is a process that the banks
wish would go on for ever, but logic says it doesn't.
Don't think that there is an economic justification for negative bond
yields: there isn't. Even if price inflation goes negative, interest rates in
a free market will always remain positive. The reason for this cast-iron rule
is interest rates are an expression of time-preference. Time preference is
the solid reason that possession of money today is more valuable than a
promise to give it to you at some time in the future. The future value of
money must always be at a discount to cash-in-the-hand, or put the other way,
to balance the value of cash today with cash tomorrow always requires a
supplementary payment of interest. That is always true so long as interest
rates are set by genuine market factors and not set by a market-monopolising
central bank, and then distorted by banking regulations.
So we have arrived close to the logical end-point in falling yields, and
in some cases we have gone beyond it. We must also conclude that negative
yields are a signal that bond prices are so over-blown that they are
vulnerable to a substantial correction. Furthermore, when the tide turns
against bond markets the downside could be considerable. The long-term real
yield on high quality government bonds has historically tended to average
about three per cent, which implies that sovereign bonds would crash if
central banks lost control of the market.
Bond bulls are on weak ground from another angle. If history tells us that
real yields of three per cent are the norm, has government creditworthiness
changed for the better, justifying a lower yield? Well, no: the accumulation
of debt across all welfare economies is less sustainable than at any time in
the past, and demographics, the number of retirees relative to those in work
and paying taxes, are rapidly making the situation far worse.
Macroeconomists will probably claim that so long as central banks can
continue to manage the quantity of money sloshing about in financial markets
they can keep bond prices up. But this is valid only so long as markets
believe this to be true. Put another way central banks have to continue
fooling all of the people all of the time, which as we all know is
impossible.
