The prolonged rally in government bonds began in 1981. This came after yet another oil price shock a...
The prolonged rally in government bonds began in 1981. This came after yet another oil price shock and changes to wage inflation. Recognising that such conditions could not be allowed to persist, politicians and central bankers joined forces to hammer out a strategy, which would kill off inflation. The initial stance was to choke ever-growing wage demands by restraint and then via a fair and well-defined pay/productivity plan.
An example of this was the Margaret Thatcher government. The UK trade unions were muted and their leadership slowly passed from the militant to the more balanced realist, which helped bring pay demands under control.
However, central banks took the process one stage further by working with governments to restrict both borrowing and spending. Tax and spend policies were cast aside in favour of monetary realism.
So successful were these policies that bond prices rallied sharply with yields falling, while inflation melted and interest rates collapsed from double digits to low single digits. The Federal Reserve Board, for example, was able to reduce US interest rates to just 1% following the collapse of the equity market dotcom boom and the terrorist attacks in 2001.
In short, global interest rates were cut and government bond yields fell to, or near to, record lows. Meanwhile, inflation remained steady and the problems of the past were declared beaten.
Of course, this process has been helped by the emergence of China and India as new economic power houses. Aided by the other emerging world countries they have been able to produce traded goods considerably cheaper or, in simplistic terms, able to export deflation.
So, here we are then in bond market Utopia. Broadly speaking, bond yields have now fallen below cash returns which, in turn, mean there are no premiums on offer for taking risk. Put in elementary terms, money lent to governments for 10 or 30 years produces a lower return than cash at banks or building societies.
My take on this is that bond markets are probably wrong. There has already been a rise in headline inflation. However, burgeoning commodity prices, which are currently getting a second wind, have yet to fully feed through into the inflation indices.
This commentary began by complementing policymakers on their success in cutting their borrowing and spending demands. Nevertheless, over the last year the pendulum has swung back in the other direction. Governments are now borrowing more and huge budget deficits are back on the agenda.
So where do bond markets go next? Near term, they may even push a little higher but, over the year, they will do well to maintain current price levels. Government bond yields are now so low they will be unlikely to cope with any unexpected bad news and there is plenty of scope for that.
Rise in headline inflation
Governments now borrowing more
Low bond yields unlikely to cope with unexpected bad news
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress