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Bond investors have been on the rack in recent days and weeks. So much so that you have to ask why economists and professional investors continue to refer to government bonds as safe and risk-free investments, relative to supposedly riskier equities.
The charge against these government IOUs is pretty damning. Take the US treasury market, regarded as the safest bolt hole on the planet. But the return on US treasuries in 2022 was minus 17.8 per cent compared with minus 18.0 per cent on stocks in the S&P 500 index. Fractionally safer, then, to the point of meaninglessness. Clearly bonds offered no diversification relative to equities.
Yes, bonds offer a contractually fixed income and, in the corporate market, rank before equities in a winding up. Yet the reality is that bonds and equities are both risky, with nuanced differences.
In 2023 so far, US equities have wiped the floor relative to bonds. This is partly illusory because the bounce in both the S&P 500 and the Nasdaq indices has been driven almost exclusively by the seven biggest technology companies. Quite a turnaround.
At the start of the year, the conventional wisdom was that rising interest rates were shrinking the present value of tech companies’ future income streams, since higher interest income today reduces the attraction of dollar earnings in the time ahead.
In effect, this seemingly ineluctable mathematical logic has been overridden by the power of the artificial intelligence story.
The enthusiasm for AI reflects a level of market euphoria uncomfortably reminiscent of the dotcom bubble, when tech stocks showed stellar performance in the face of tightening monetary policy. In the meantime, fears of recession are in retreat.
But to return to bonds — the great bull market that started in the 1980s is clearly over. And recent nervousness has many causes ranging from the Fitch rating agency downgrade of US treasuries, to worries about endemic budget deficits and the withdrawal of Japanese capital from the US (a response to the Bank of Japan’s loosening of its yield curve control policy).
The more fundamental point, made by William White, former head of the monetary and economic department of the Bank for International Settlements, is that the world is moving from an age of plenty to an age of scarcity.
Numerous trends since the end of the cold war — the expansion of global supply chains, growth in the global workforce, trade growth outstripping increases in gross domestic product, less spending on guns and butter — are now going into reverse.
At the same time, energy supply is constrained by concerns about climate change and security, while record levels of both private and public debt restrict policy options as well as being a drag on growth.
This paves the way for a more inflationary world, in which inflation and interest rates are likely to be more volatile.
White foresees continuing inflationary pressures and higher real interest rates for much longer than most people now expect. If he is right, the bond market’s ability to inflict financial instability bears thinking about.
In the US, there has been a phoney peace since Silicon Valley Bank and other regional banks foundered in March because of the collapse in the market value of their securities holdings.
Yet the US Federal Deposit Insurance Corporation estimates that unrealised losses on American banks’ securities amounted to $515.5bn at the end of March, equivalent to 23 per cent of the banks’ capital.
This is quite a deadweight at the start of a looming commercial real estate disaster that will soon inflict further damage on bank balance sheets. That problem is replicated across much of the developed world.
It is central banks, however, that are suffering the biggest balance sheet damage due to rising bond yields, as a result of their asset purchasing programmes. On March 31st, for example, the mark-to-market losses on the Federal Reserve’s securities holdings stood at $911bn. That is nearly 22 times its mere $42bn capital.
How, you might ask, can the dollar remain the world’s pre-eminent reserve currency if it is backed by a hopelessly insolvent central bank?
The immediate answer is that central banks’ most valuable asset is not on the balance sheet: seigniorage, or the profit on manufacturing money. In other words, central banks can print their way out of trouble.
But only up to a point. As the Germans learned during the Weimar Republic, markets may conclude that the central bank emperor has no clothes.
The US is not there yet. And there are no good alternatives to the dollar and US treasuries. For investors, the message pro tem is that bonds, while unsafe and very risky, offer a substantial yield uptick relative to central banks’ inflation targets of around 2 per cent. The financial world is nothing if not paradoxical.
john.plender@ft.com
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