Beginning of a bond meltdown?

‘Adam Smith observed, “There is a great deal of ruin in a nation.” There is certainly a great deal more potential ruin in the government bond markets’

Tim Congdon

Fears of rising dollar interest rates upset financial markets around the world. Every asset is a claim of an income stream extending into future periods, and the value of the income from the more distant periods is discounted more heavily than the income from nearby periods. A cardinal principle of investment is therefore that the higher the rate of discount, the lower is the price of assets. Meanwhile, the influence of American interest rates is global and pervasive. Even investors in Japanese tech stocks and German commercial property know that they must watch movements in American bond yields and the funds rate set by the Federal Reserve.

The Fed kept its funds rate at between zero and 0.25 per cent for seven years from the end of 2008, to help borrowers and asset prices, and to ease the American economy out of the Great Recession. Although it started to edge interest rates upwards from early 2016, even in the summer of that year the yield on 10-year fixed-interest Treasury bonds was as low as 1.5 per cent and policy tightening seemed gentle. But 2018 has seen a resurgence of inflation worries: the Fed funds rate is now over 2 per cent and the 10-year yield has climbed to above 3.2 per cent. In a Daily Telegraph story last month, Ambrose Evans-Pritchard warned that the doubling of American bond yields in little more than two years might “trigger a debt meltdown”.

A doubling of American bond yields in a relatively short period of time does matter. The psychology of financial operators may be shifting, with even the glamour stocks of the American bull market tumbling since mid-September. But a curious feature of the current upturn in bond yields is the short memory of today’s market commentators. In the context of the last decade, a doubling of American bond yields is a big event; in the context of the almost 75 years since the Second World War, a yield shift from 1.5 per cent to 3.2 per cent is trivial.

Let us look, first, at American bond yields in their biggest and worst bear market of all time, from the mid-1950s to 1981. For much of 1954 the 10-year Treasury yield was about 2.3 per cent, with the American public and the US’s investing institutions confident that their nation would prevent inflation and maintain the real value of their currency. Over the next generation this confidence was shattered. Several years in the 1970s suffered annual increases in the producer price index of over 10 per cent and a few were still worse at more than 15 per cent. A 15-per-cent-a-year inflation rate halves the value of money in five years. No wonder that investors fled the bond market, with the 10-year Treasury yield climbing briefly to over 15 per cent in late 1981. Obviously, the US government debt meltdown over the 27 years to 1981 — with yields rising more than six times — overshadows what has happened since the summer of 2016.

What about the record on this side of the Atlantic? It was even worse. Victory in the Second World War duped many investors into regarding the long-run stability of the value of their nation’s money as a given. One of the most familiar securities in wealthy families’ portfolios was known as “Consols”, after the consolidation of the national debt by the Chancellor of the Exchequer, Sir Henry Pelham, in 1752. Consols paid 2.5 per cent a year on £100 of nominal stock held and might continue to do so into the indefinite future, since the British government had the option never to repay it. In October 1946 Consols had a yield of just above 2.5 per cent and their market value was only a little beneath par.

Over the next 30 years monetary policy was bungled by governments of both the major political parties. The annual rate of retail price inflation exceeded 27 per cent in 1975 and the Bank of England’s Minimum Lending Rate (its then phrase for “Bank rate”) went up to 17 per cent in 1979. At the worst point in 1974 the yield on Consols, at almost 16.8 per cent, was above the market price of the stock: £100 nominal could be bought for under £15. Anyone who invested £100 in Consols in 1946 had in that sense lost 85 per cent of their money. When further allowance is made for the collapse in the real value of the pound, the loss — in terms of purchasing power — was far greater, and amounted to more than 96 per cent.

Anyone who thinks that the doubling of the US 10-year yield since July 2016 is an epoch-making catastrophe might recall Adam Smith’s observation, on hearing reports that Britain might lose the American colonies, “There is a great deal of ruin in a nation.” There is certainly a great deal more potential ruin in the world’s government bond markets. Indeed, the government bond meltdown may have only just begun.

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