In memory of Dr. Andreas Höfert

The ever more bizarre government bond market…

| Posted by: Andreas Höfert | Tags: Andreas Höfert

Spotting an asset price bubble before it bursts is tough. Qualifying the frenzy before a bubble explodes as a "bubble" in hindsight is easy. This is why many central bankers still follow the Greenspan doctrine, which states that it is not the role of monetary policy to "pop" asset bubbles in the making. Instead, central banks are there to mitigate and sweep up damages after a burst.

Today, central bankers find it difficult to argue against this doctrine. In my view, despite any protests they advance (see for example the latest blogs from former Federal Reserve Chairman Ben Bernanke), central bankers' current ultra-loose monetary policies are at least partly responsible for the extremely high prices and concomitant low interest rates now prevalent in government bond markets.

Citi research indicates that central bank purchases of assets may match the total net issuance of stocks and bonds (estimated at USD 1,500 billion) in 2015, a situation which occurred in 2013. J.P. Morgan Asset Management has calculated that by end-February 2015, 67% out of the USD 22,000 billion in developed world government bonds were yielding below respective national rates of inflation, meaning negative real interest rates. Moreover, 7%, or USD 1,540 billion in developed world government bonds had negative nominal yields, meaning that investors buying those bonds were actually paying governments to hold their money - and receiving no interest income for a specific period.

Last week, Switzerland issued a 10-year government bond with a negative interest rate, the first nation ever to do so. Since the Swiss franc floor was lifted on 15 January, the whole Swiss yield curve up to 16 years has been in negative territory. Germany is not far away, having sold a five-year government bond with negative yield a month ago, and seeing its 10-year interest rate hovering just above 0.1%.

Even more "problematic" countries like Spain or Italy are experiencing historical low interest rates. And by history, I don't mean the last fifty years. In Italy, Genovese interest rates in 1664 and 1665 stood at 1.23%, their historical low point. This floor was broken on 10 March. Meanwhile 10-year Italian government bond yields have rebounded to a still very low 1.30%. This is a country with a public debt-to-GDP ratio of 132%.

Asset bubbles are usually based upon extreme optimism or pessimism. Optimistic bubbles are the ones which rely on a narrative of the unknown. Emerging markets or new technologies are prone to these. Investors have repeatedly fallen for tales of Eldorado at the other end of the World (from the South Sea bubble in the 18th century to the Asian crisis) or of technological grails (from 19th-century canals and trains to the bubble).

Pessimistic bubbles, by contrast, rely on a narrative of scarcity. Commodities and real estate are particularly prone to this. Investors have often believed that some raw material would run dry or that a certain real estate market could only go up because everyone wanted to live there.

Neither narrative explains the present government bond market. Government bonds are not neither exotic nor new and hence prone to misevaluation due to ignorance. Nor are they scarce (although governments might want us to believe that).

Economic Nobel Prize laureate Robert Shiller, one of the true and rare economists who foresaw both the 2000 bubble burst and the 2007/8 financial crisis, recently wrote an open editorial (see:, "How scary is the bond market." His sober conclusion, "not too much," meaning not too scary, is somewhat mitigated by "It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence." My interpretation of this is, "I cannot foresee it, but you have been warned!"