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Central Banks in Wonderland: The Coming Bond Crash

Global bonds are worth over $100 trillion, while global stocks are worth only $64 trillion. Daily bond trading is $700 billion against $200 billion for shares. Stock markets hog the limelight.

But bond markets matter more. Danger: they have become big bubbles. The surest sign of a bubble is that craziness is viewed as the new normal — like negative interest rates for European and Japanese bonds. Money is valuable, so people historically have paid interest to borrow. That has induced saving, promising savers a decent return.

Time to Get Loanly

But today’s negative interest rates mean that savers lose money, and borrowers are paid to borrow. That’s right out of Alice in Wonderland. Yet, Wonderland is now regarded as normal by global markets, and as desirable by the IMF.

The lower the interest rate, the higher the bond prices. So, ultra-low rates mean stratospheric bond prices. Sky-high prices for bonds that yield nothing represent irrational exuberance, reminiscent of the dotcom bubble of 2000 and the derivatives bubble of 2008.

After the 2008 crash, central banks of developed countries pumped trillions into financial markets to revive growth. They slashed short-term interest rates to zero, hoping cheap money would stimulate fresh investment.

However, long-term rates (that matter more for investment) remained higher. So, central banks went for ‘quantitative easing’ (QE) — massive purchases of long-term bonds — to lower long-term rates.

This had limited success in the US and little in Europe or Japan, where businesses still refused to borrow and invest. Growth remained tepid. The IMF and others believe QE revived the US.

QE there ended in 2014, and the Fed raised the short-term interest rate to a still ultra-low 0.25-0.50 per cent. The economy revived in 2015, but slowed again in 2016 to barely 1 per cent.

While doing little for growth, QE robbed savers of a return on their savings. Ten-year US gilts today yield just 1.6 per cent. So, a million dollars invested in 10-year gilts will produce an annual income of only $16,000, far below the poverty line of $24,500 for a family of four.

A whopping $11 trillion of bonds now carry negative yields in several countries: Japan, Germany, Switzerland, Denmark, Austria, Sweden, Holland and Finland.

Central banks say the big risks today are deflation and stagnation, which should be combated by negative interest rates. IMF officials accept that negative rates carry a risk of financial instability, but think the bigger risk is stagnation and deflation.

They hope growth will gradually resume, interest rates will gradually become positive again, and we can all move, like Alice, from Wonderland back to the normal world. Alas, the notion that central banks can deflate bubbles in a controlled manner is probably a delusion of grandeur.

Far more likely is a massive market crash when central banks try to exit Wonderland. Since all asset markets are highly correlated today, a bond crash could mean a crash in all markets, causing another financial crisis and recession. This is not certain, but is a clear risk. QE means that major central banksare massive holders of bonds, including corporate bonds.

More than $3 billion of corporate bonds now carry negative yields. This madness now threatens bank stability. Financial regulations do not require banks to mark to market gilts, save those earmarked for trading. But all corporate bonds must be marked to market.

The Bond Loosens

Rising corporate bond prices have boosted bank profits. But when interest rates ultimately rise and QE is unwound, bond prices could suffer a panicky crash, causing huge losses for banks, pension funds, mutual funds and insurance companies.

That could mean another big financial crisis. The US Fed has stopped buying bonds, but has not yet sold its massive holdings, as it must do some day. So must the European and Japanese central banks.

Backed by the IMF, they believe that day is still far off, that European and Japanese economies are so anaemic that interest rates should remain zero or negative for quite some time.

So, an exit from Wonderland is not in sight. This has lulled markets to believe that negative yields are not craziness but the new normal. Layman will ask: why on earth will anybody buy a bond with a negative interest rate? Answer: in the hope that rates will get even more negative, so bond prices will rise further, and you can sell at a profit to another guy who believes rates will get even more negative and enable him to sell at a still higher price.

Ponzi ahoy! The bond market used to be dominated by institutions in search of safe, stable yields. It has now become a haven for speculators betting on ever more negative interest rates that produce capital gains.

This will probably end in what economists call a Minsky moment, when reality finally hits the speculators in Wonderland, causing a panicky crash. Central banks think they can orchestrate an orderly winding down of markets. History suggests otherwise: markets typically overshoot. Tighten your belts folks, stormy weather lies ahead.

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