{"id":30989,"date":"2012-07-19T23:20:57","date_gmt":"2012-07-20T03:20:57","guid":{"rendered":"http:\/\/countingpips.com\/forex-news\/2012\/07\/what-are-the-bond-markets-telling-us\/"},"modified":"2012-07-19T23:20:57","modified_gmt":"2012-07-20T03:20:57","slug":"what-are-the-bond-markets-telling-us","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex-news\/2012\/07\/19\/what-are-the-bond-markets-telling-us\/","title":{"rendered":"What Are the Bond Markets Telling Us?"},"content":{"rendered":"

By MoneyMorning.com.au<\/a><\/strong><\/p>\n

Most small investors spend the majority of their time looking at stock markets. However, I\u2019ve always believed that to get a deeper understanding of what\u2019s really going on, the best thing you can do is to try to figure out what the bond market<\/strong> is telling you.<\/p>\n

<\/span><\/p>\n

Why? Because the yields on government bonds have a major impact on the price of virtually all investment assets. Put simply, rising yields tend to reduce the value of assets, while lower ones tends to make them go up. That\u2019s because government bonds<\/a> are supposed to be the \u2018safe\u2019 assets.<\/p>\n

That\u2019s very debatable, but assuming the market believes this, then if the yields on government bonds go up, then the yields on other assets such as shares or property should go up too in order to remain attractive. These higher yields are usually achieved because prices fall.<\/p>\n

The current action in the bond market<\/a> is probably the biggest conundrum facing investors today. Despite the massive debts held by governments, yields on the likes of UK gilts and US Treasuries<\/a> are at record lows.<\/p>\n

Is the bond market one massive bubble like dotcom stocks in 1999 or property in 2006, or is it telling us that we face years of Japan-style deflation<\/a> and stagnation?<\/p>\n

The Bond Market \u2018Bubble\u2019:
\nIrrational Exuberance or Plain Realism?<\/h3>\n

<\/center><\/p>\n

Have a look at the chart below. It shows the redemption yield on ten-year UK government bonds, less the rate of inflation, since 1956 \u2013 the real yield. This chart is used by the bond bubble camp to claim that government bonds are massively overvalued and ready for a crash.<\/p>\n

UK Real Ten-Year Bond Yields<\/h4>\n

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<\/div>\n

They argue that no rational investor should accept bond yields less than the rate of inflation. Investing should be about preserving and growing the purchasing power of your money, therefore buying bonds in the current market doesn\u2019t make sense.<\/p>\n

I\u2019ve got a lot of sympathy with this view of the bond market. With ten-year UK gilts at 1.55%, there\u2019s little to lose in holding cash.<\/p>\n

However, I can also understand why big companies might want to deposit large amounts of cash in the bond market rather than a bank. Deposit insurance limit might cover most small investors\u2019 needs, but it doesn\u2019t help companies with significant cash holdings.<\/p>\n

The bubble camp also points out that the UK and US bond markets<\/a> have been heavily manipulated and propped up by the money-printing and bond-buying of their respective central banks. This has in effect, resulted in a one-way bet for investors.<\/p>\n

With heavy central bank buying of bonds pushing up prices and pushing down yields, there\u2019s been some easy money to be made in the bond market. This can\u2019t go on forever, argue the bond bears.<\/p>\n

Again, I have a lot of sympathy with this view. But let\u2019s ask ourselves for a moment: what if the bond market is right? What if the UK, US and European economies are actually going the same way as Japan<\/a>?<\/p>\n

If that\u2019s the case, and we\u2019re facing low economic growth and falling prices (deflation), then bond yields could go even lower. Is this the outcome that Western bond markets are correctly anticipating?<\/p>\n

Are the UK and the US Bond Markets Turning Japanese?<\/h3>\n

<\/center><\/p>\n

The arguments made by the bond market bears are very sensible, but I\u2019m not in a hurry to dismiss the bond market. Compared to the equity market, it\u2019s often seen as the smart money. It\u2019s always worth at least considering the possibility that it\u2019s priced correctly.<\/p>\n

So could we be heading for a deflationary bust despite the best efforts of the Federal Reserve and the Bank of England?<\/p>\n

Let\u2019s have a look at what has happened in the Japanese bond market.<\/p>\n

Japanese Ten-Year Bond Yields (%)<\/h4>\n

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<\/div>\n<\/p>\n

As you can see, in 1995, more than five years after the Japanese stock market peaked and the economy started to cool, Japanese government bonds (JGBs) were still yielding 4.5%. Seventeen years later, yields on JGBs are now sitting at 0.77% as repeated attempts to stimulate the economy and increase inflation have failed.<\/p>\n

This is because Japan is still stuck in what is known as a ‘balance sheet recession’ – a recession caused by too much debt. The focus of consumers and companies has been to get rid of debt, rather than spend more money. Printing money and cutting interest rates doesn\u2019t do any good in this scenario, because there is no desire to spend, just to save and pay off debt.<\/p>\n

Most of the Western world is currently in a similar situation. It too has way too much debt and unfunded welfare liabilities. The credit boom of the mid-2000s means that debt has to be repaid and\/or bankruptcies need to rise. Governments and central banks have been doing everything they can to prevent the market from doing its job and a natural correction happening \u2013 just as occurred in Japan.<\/p>\n

This debt overhang means that despite the large amounts of money printing, the UK and US economies are still stagnating. Money printing is barely keeping the huge deflationary forces at bay.<\/p>\n

So could bond yields fall further? Respected economists such as Gary Shilling think so. Shilling has a fantastic record in predicting major economic events and is a prominent deflationist \u2013 have a read of his book The Age of Deleveraging<\/em>. Earlier this year, in a television interview he discussed the possibility of the yields on 30-year US bonds hitting 2% (they are currently 2.58%).<\/p>\n

How is this possible? Well, looking back at Japan again, you can see that even with yields of less than 1% you can still have positive real yields (in other words, you can still make a \u2018real\u2019 return) if you have deflation. If this is the fate that awaits the UK and US then rather than being hysterical and heavily manipulated, the bond markets are ahead of the game.<\/p>\n

Japanese Real Yields (%)<\/h4>\n

<\/center><\/p>\n

<\/div>\n<\/p>\n

What Happens Next: Deflation Then Inflation?<\/h3>\n

<\/center><\/p>\n

So there are good grounds to argue that the bond market may be right in predicting that deflation is the major threat in the short-term.<\/p>\n

The forces of deflation are so great that the central banks will have to print lots more money<\/a> than most people expect to create inflation and erode the massive debt burden we face. Only then will the bond market bubble pop and stock and property markets will crash.<\/p>\n

The other alternative is for governments to get out of the way and let the markets correct. But for politicians this would be akin to turkeys voting for Christmas.<\/p>\n

In Greece, Ireland, Portugal and now Spain, the bond market \u2013 free of central bank money printing \u2013 has done its job and punished reckless economic behaviour. In the UK and US, the central banks have so far postponed the day of reckoning, but that day will surely come. And when it does, they seem to be voting for an inflationary rather than a deflationary bust.<\/p>\n

So What Can You Do With Your Money if the Bond Market Collapses?<\/h3>\n

<\/center><\/p>\n

It\u2019s not easy to predict when the bond market will collapse as central bankers get their way and spark inflation<\/a>. The good news is that you don\u2019t have to.<\/p>\n

While government bonds could remain at low yields \u2013 and could go lower \u2013 we still wouldn\u2019t own them. There\u2019s little upside and lots of downside. If you are worried about deflation, then as an individual, holding cash is a safer bet. It also gives optionality to take advantage of falling prices (in other words, if you\u2019re sitting on cash, you can quickly deploy it when you spot bargains).<\/p>\n

Hold some gold<\/a> too as a hedge for when inflation rears its ugly head, as politicians try to print us out of trouble.<\/p>\n

Finally, any equity investments should be in companies that have pricing power and so are able to cope with both inflation and deflation<\/a>.<\/p>\n

Phil Oakley<\/strong><\/p>\n

Contributing Writer, Money Morning<\/strong><\/p>\n

Publisher\u2019s Note:<\/em>This is an edited version of an article that first appeared in MoneyWeek (UK)<\/a><\/p>\n

From the Archives…<\/strong><\/em><\/p>\n

The Credit Market Debt Bubble and the Role of Gold<\/a>
\n13-07-2012 – Greg Canavan <\/p>\n

How to Survive and Thrive from China’s Bust<\/a>
\n12-07-2012 – Kris Sayce <\/p>\n

Payday Loans: Why This Lender of Last Resort Isn’t the Bad Guy<\/a>
\n11-07-2012 – Kris Sayce <\/p>\n

What A Slowing Chinese Economy Means For Pork Chops<\/a>
\n10-07-2012 – Dr. Alex Cowie <\/p>\n

Late News: Bankers Rig Interest Rates, No-One Fired<\/a>
\n09-07-2012 – Dr. Alex Cowie<\/p>\n

\n<\/img><\/a> <\/img><\/a> <\/img><\/a>\n<\/div>\n


\nWhat Are the Bond Markets Telling Us? <\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

By MoneyMorning.com.au Most small investors spend the majority of their time looking at stock markets. However, I\u2019ve always believed that to get a deeper understanding of what\u2019s really going on, the best thing you can do is to try to figure out what the bond market is telling you. Why? Because the yields on government … <\/p>\n

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