Bonds are clearly in a bubble – but when will it burst?

With more and more government debt trading on negative yields, the bond bubble continues to swell. John Stepek looks at what could prompt it to burst.


Lending to the German government will cost you money

The bond bubble is going from mad to worse.

The average yield across Germany's bond market known in one of those wonderful German words as the Umlaufrendite has fallen below 0% for the first time in history.

Meanwhile, more than $10.4trn of government debt globally now trades on negative yields, according to ratings agency Fitch.

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Either the bond market is pricing in a very extreme negative economic outcome, or it's incredibly overvalued.

One way or another, someone's going to get a nasty surprise

The bond bubble continues to swell

Like most bubbles, this is obviously nuts.

It didn't make fundamental sense for a tiny stretch of central Tokyo to be worth more than the whole of California in the late 1980s. It didn't make sense for companies that consisted of nothing more than a business plan and a rudimentary website to be worth billions in the late 1990s. And today, it doesn't make sense that hugely indebted, economically fragile governments can literally charge people to lend them money.

Yet, like most bubbles, you can also see why this has happened.

In the 1980s, Japan was the next superpower. America was over. (Take a glance back at Western popular culture of the 1980s and even the early 1990s the spectre of Japanese supremacy and US decline is all over it, from visionary sci-fi like Neuromancer to trashy thrillers like Rising Sun.) And while today shows that Japan didn't quite take over the world, it's unquestionably true that it made a lot of economic progress in a very short space of time.

More to the point, people who had bet on Japan early made an awful lot of money and kept making more and more money, until even the most bearish had to crack. Then the bubble burst.

The tech bubble made a lot of sense too. The internet was going to transform the way we did business. It has done, and it still is doing. We worry about robots, but the truth is that right now, anyone who works in retail, publishing, entertainment, finance, even law, is having their jobs threatened by the simple ability to order and take delivery of goods and services from the comfort of your own home.

Yet even after the internet has arguably outstripped even the most optimistic forecasts of the late 1990s, the tech bubble was still a bubble. The valuations of most individual companies were not justifiable. In the end, prices kept going up simply because people had made so much money in the face of a huge amount of scepticism everyone started to assume they must be missing something. Then the bubble burst.

So what about the bond bubble? It makes sense too. Growth is over. Debt is crushing our economies. Inflation seems impossible to come by. We're all Japanese now.

Better yet, central banks are there as the buyers of last (and often first) resort. If you bought bonds this year, it doesn't matter about what happens when they mature you've done well on the capital side, particularly if you played the currency right.

German government debt is up around 4.2% this year, according to Barclays, cited in the FT. That's better than most stockmarkets. Japanese government bonds are even better up more than 5%. And if you'd bought in using a weakening currency, you'd have made even more money.

Does the ongoing strong performance of bonds mean we're missing something, or that there's no bubble here? Nope. It just highlights yet again, that bubbles last for an awful lot longer than they should (which makes sense if market prices corrected reliably when the underlying assets moved out of line with the fundamentals, then bubbles would never form).

As John Plender points out in the FT, past recoveries from similar crises offer a sobering lesson for bond investors. After the 1890s Latin American debt crisis, US bonds lost 1% a year from 1900 to 1910, in real (after-inflation) terms.

Doesn't sound too painful? Think again. From peak to trough, from 1900 to 1920, US bond investors lost half their money. The data, says Plender, is worse for the post-Great Depression period. And they're worse again if you use UK rather than US bonds.

"The period of maximum danger for bond investors will be when growth in Europe strengthens and Fed policy gains potency as a result" (because the Fed will finally be able to raise rates in the US without attracting swathes of capital from around the world thus tightening monetary policy by more than it wants as a result).

The thing is, if past bubbles are any guide, even as this reflation is happening, and the outlook is getting more and more grim for the sustainability of the bond bubble, investors will be dismissing signs of a turn and sticking to their guns. So even when inflation starts to return, don't expect mainstream market commentary to recognise it.

As we thought, Janet Yellen has ruled out a rate rise this month

The key bit of her speech was what was missing from it. A fortnight ago, she said that she expected a rate move "in the coming months." She didn't say that this time.

Markets reacted with relief, as you might expect. It's quite something that the omission of just four little words from a speech by one person can move markets, but that's the financial system we live with.

Remember pretty much since the Alan Greenspan era, it's paid off to bet on the Fed's ongoing desire to keep money as cheap as is humanly possible. Yellen will take every excuse she gets to keep rates as low as she can until inflation figures force her to do otherwise. Stick with those weak dollar trades.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.