The Government Bond Market



Janet in Wonderland
Anyone who believes that financial markets are rational is not looking at the current government bond markets.   The U.S. 10-year government bond is paying around 2.5%.   Believe it or not, the 10-year Spanish government bond is paying less.  The German 10-year government bond is paying a little over 1%, less than a 2-year U.S. bond.

If you were not a finance major, skip this paragraph.  The yield curve is incredibly flat.  It is only this way because the Fed hasn’t realized yet the Great Recession has been over for five years.  More sinister explanations rely on conspiracy theories.  When given the choice, I always go with stupidity.

According to CNBC (yes, I’m still addicted to my financial soap opera), the interest rates on German and Spanish 10-year bonds are at a 200-year low.  I don’t know how they know that.  Germany didn’t exist 200 years ago but Prussian war bonds probably did.  More surprising, CNBC says that Dutch 10-year government bonds are selling at the lowest interest rate in 500 years.  That’s possible since Amsterdam had the most developed financial markets 450 years ago.  The only problem is that the Netherlands as a country didn’t exist 500 years ago.  But, if you can’t believe CNBC, who can you believe?

The interest rate on the German 10-year government bond is lower than the interest rate on the 2-year U.S. government bond.  It implies that Germans believe there’s a better chance the German government will not allow any inflation over the next 10 years than Americans believe their government will immediately lower the inflation rate to zero and keep it there for two years.  Hard to choose.  Is there a door number three? 

If you buy a 10-year U.S. government bond, you are buying an asset with a real (after inflation) interest rate barely above zero.  You are betting that the inflation rate won’t go up at any time during the next 10 years.  If inflation does go up sometime in the next 10 years, you will be receiving a negative real interest rate during that period.  You are subsidizing the Federal government and the national debt.  Thank you on behalf of American taxpayers.  And I hope for your psychological well-being you’re not a Republican.

But why are government interest rates so low?  Two major reasons given - lots of global liquidity that wants low-risk assets and central bank action in the U.S., Europe and Japan to artificially keep interest rates low.  The first explanation is hard to swallow because of massive increases in demand for higher-risk assets (read stocks).  And zero or negative real rates of return seem to be a high price to pay for financial diversification or resource allocation.  Maybe I’m paranoid (maybe?) but the second reason benefits the biggest borrowers of all – governments.

But wait.  It’s worse than that.  If the market interest rate on a U.S. bond with 10 years to run were to rise 1%, the market value of your bond would go down by about 7.5%, that is, three years of interest income.  Hopefully, you wouldn’t have to sell it.  You’re betting that none of the following happens – you don’t become unemployed, divorced, a parent, sick, disabled, have kids go to college, have kids move back home after college, have a flood in your basement or own stocks that go down. You know, life. 

The market value of the bond would rise towards par unless interest rates went up again.  You would take another temporary hit.  Eventually, at maturity, the bond would return to par and you would have no capital loss.  But for part or all of the 10-year period, you would be earning a negative rate of return.

The odds are pretty good that you own a piece of the national debt and are subsidizing all us free-loading senior citizens and home buyers with mediocre credit ratings. Virtually all pension plans and 401(k)s own U.S. government debt. 

With so much liquidity sloshing around the world, (see the last blog on the Fed and Monetary Policy), money managers and corporate treasurers have to put the money somewhere. They appear to be willing to pay governments to take their money.  Well, at least take their clients’ or stockholders’ money. Who are foolish enough to pay management fees to the money managers and large salaries and bonuses to corporate treasurers. You can bet they aren’t dumb enough to buy government bonds for their personal portfolios.

So the danger is inflation. What causes inflation? What if the U.S. and Spain and the other countries do a bunch of politically-nasty things (see Simpson-Bowles report) to balance their budgets and fight inflation?  There’s still a problem.  Inflation is also caused by “external shocks,” a fancy way of saying an unanticipated event beyond the control of a particular national government.  Commodity prices go up.  Remember the inflations caused by OPEC I and OPEC II?  What if Russia decides to teach Europe a lesson in realpolitik and reduces or shuts down oil and natural gas flows to European countries in the middle of winter?  Or arbitrarily raises natural gas prices, as they just did to Ukraine?  Or some group blows a hole in one of the large natural gas pipelines that runs through western Ukraine to Europe?  (If I were a sneaky planner for the Russian FSB, the new version of the KGB, that’s what I would do and then blame it on a Ukrainian far-right nationalist group.)  Or some other plausible scenario – wars in the Middle East, droughts, asteroids hitting the earth (not as unlikely as you think).  A president who starts a war for no ostensible reason.  Black swans everywhere.

You are also betting that your government’s bonds won’t get downgraded enough by the credit-rating agencies to the point where it indirectly lowers the market value of existing bonds.

So, if you buy a U.S government bond or a municipal bond issued by the great state of New Jersey, you are betting that the people running those governments can forecast accurately and without bias, and will add the numbers honestly and ignore special-interest politics.  They will pursue policies that will promote economic growth and not raise prices, and not some ideological or personal agenda, like trying to get re-elected with large amounts of special interest-group money. 

If you are buying government bonds, then you agree with the immortal words of Tug McGraw, “Ya gotta believe!”

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For some background, see an earlier post on Government Finance.


  

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