No growth or a fear bubble?

Duncan Weldon
Jan 11, 2015 · 6 min read

The most striking feature of financial markets today is low government bond yields.

I’ve been staring at the charts for a while now and the more I look at them, the more I worry that one of two things is happening: either growth prospects in the developed world are the lowest they’ve been in decades or the world is experiencing one of the biggest financial bubbles in history.

I’m not sure which idea terrifies me the most.

But first, the background.

Across the advanced economies — with the notable exception of Greece — government’s borrowing costs are either at or very near to historic lows.

The UK government can borrow for ten years at 1.6%, Germany at 0.5%, the US at 2.0%.

So why are yields (which move inversely to the price — a lower yield means the price of bonds is high) so low?

Various explanations can be offered.

It could be as simple as supply and demand being out of balance. Investors in turbulent times want to hold safe assets , but the global supply of safe assets has fallen since 2008. Much of what was once seen as ‘safe’ is now viewed as ‘distinctly risky’ — the debt of the US mortgage giants Freddie and Fannie Mae for example, or the debt of much of the so-called Eurozone periphery.

But as an explanation for low yields across the board, this doesn’t quite work. It may explain the low level of yields in the UK, US and Germany and some others but the issue is much, much broader. Spanish government 10 year bonds are currently yielding just 1.7% and the Italian equivalent just 1.8%.

Or this could be about QE. Investors’ expectations that the European Central Bank is about to starting buying soveriegn debt is a strong reason to get ahead of that buying by purchasing such bonds themselves. This pushes the price up and the yield down. QE in the UK and US has no doubt been a large factor in pushing down yields on US Treasuries and UK gilts.

But again with US QE seemingly finished and UK QE at the very least on pause, I’m not quite sure this can explain the global phenomena being seen.

Some point to the possibility that ‘financial repression’ is under way. This would mean that government’s (through a combination of QE and regulation) are creating a false market in their debt. Forcing financial institutions to hold debt at low interest rates and hoping to use inflation to bring down it’s real value.

Again, there may — in some parts of the world — be some truth in this, but it doesn’t work as an explanations for global developments.

As Citi’s Steven Englander has pointed out, the average 10 year yield of the G3 countries (the US, Germany and Japan) recently slipped below 1% for the first time on record.

And crucially as he argues:

“this is not happening during the panic phase of a crisis, but after the panic is over… a sign that investors think we are going nowhere for a long time”

That’s an important point. During an acute crisis, one would expect investors to put their money into safe havens like government debt. Investing becomes less about the return on capital and more about the return of capital — in other words it’s less about making money and more about not losing it.

But we are not in an acute phase. Englander’s remarks point to the first possible explanation for low yields across the board.

This is fast becoming the popular explanation for low borrowing costs across the West. One endorsed by an FT leader this week.

The argument is that low yields simple reflect the bond markets belief that interest rates are going to remain very low for a very long time. UK thirty year yields at just 2.4%, US at 2.6% and German at an almost unbelievable 1.3%.

Expectations of low central bank rates for years ahead imply explanations of low inflation and weak growth.

That might reflect what some have called Secular Stagnation. The idea that aggregate demand is weak and that the rate of interest required to generate full employment and decent growth is now negative.

Or it could be a belief in a supply side driven explanation of weak growth. The kind of argument associated with Tyler Cowen or Robert Gordon that the technological progress that drove growth in the nineteenth and twentieth centuries has slowed.

Whether the source of this stagnation and low growth is to be found on the demand side or the supply side of the economy matters hugely for policy but in terms of living standards the prognoses are equally grim.

If low yields do indeed reflect a view that interest rates are going to remain low for years to come, that inflation will be weaker in the future and that growth is going to be materially slower that’s a reason to be pretty gloomy.

It essentially reflects what could be thought of as ‘Japanificiation’ of the West. Lost decades of low growth and potentially deflation*.

If that all sounds too gloomy, consider the other explanation.

The other global explanation that works in explaining low yields is what could thought of as a bubble in fear.

Maybe growth prospects are not as weak as they appear, central banks will be able to return interest rates to more normal levels in the years ahead and inflation will not remain so low.

If that is the case then the current price of government debt — and the interests rates attached — are fundamentally wrong.

What, in effect, has happened is that investors have become too gloomy and in their desire to avoid anything risky have pushed up the price of anything that could be perceived as ‘safe’ (and remember something is safe until it isn’t) to unsustainable levels. QE may have at an impact in driving this.

As with any other bubble there is a plausible story to be told that this isn’t a bubble — that this time is different. “The internet is going to fundamentally change the economy and business” justified buying tech stocks at inflated values, just as “the economy is going to be very weak” can justify buying German ten year bonds with a yield of 0.5%.

And that story can be true even if there is a bubble — the internet did fundamentally change the economy and business but tech stocks in the late 1990s where still over-valued and in bubble territory.

That might not sound too bad. Bubbles happen — in tech stocks, in houses, in the debt of subprime borrowers in the US, etc.

But a bubble in government debt would be something else entirely. First as these are some of the deepest and most liquid markets in the world, a bubble here should be less likely. Second as a bubble in something perceived to ‘safe’ could have a much more profound impact and finally because government bond yields are the benchmark against which other assets are priced.

If the price of the benchmark is wrong, then a lot of other prices could be wrong.

A long term weakness in global growth is something to fear, a bubble in global bonds might be even more scary.

* Japanese government bonds have continued to hit new lows over the last two decades even as the government’s debt pile has soared. Not for nothing as Japanese Government Bonds often called the widow-maker trade. Obviously ‘mispriced’ (how can the interest rate be so low given the outstanding stock of debt is rising?) and so something that should obviously be shorted (i.e. the price of the bonds should go down and the interest rate up). The problem for those entering that trade is that ‘mispriced’ bonds keep getting more mispriced.

Duncan Weldon

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Economics, finance. General rambling. Head of Research at Resolution Group. All views are my own.