This Is How Big the Bubble in Sovereign Debt Is

July 4 2016

The very day the previous bull market in gold came to a halt, the bull market in fixed income began. Thirty-six summers later this bull market is coming to its climax. But no one seems to be aware of the speculative fever on the bond market. This week even the longest dated Swiss bond (brace yourself: this bond matures in 2064) went below zero. The entire Swiss yield curve is negative now. Yet, curiously, we tend to associate speculative manias almost automatically with stocks and commodities. This is how big the bubble in sovereign bonds is and these are the consequences everyone conveniently ignores.

This Many Bonds Have a Negative Yield

The numbers are staggering. Last month, almost 1,300 billion dollars in bonds began yielding negative. We are now at a mind-boggling grand total of 11,700 billion dollars of negative-yielding bonds. Close to 40% of worldwide public debt carries a negative interest rate. Governments all around the world are going deeper into debt and getting rewarded for it. Of course, this entire façade is orchestrated by one institution and one institution only: the central bank.

One of the consequences in the aftermath of Brexit has been that the bubble in sovereign debt was blown up even further.

The only motive for investors to continue to buy government bonds is pure and simple speculation, “the greater fool theory.” It is the same kind of speculation that turned the Dutch tulip mania in the early 1700s into an unforgettable lesson of history. The speculative fever in government bonds is based on something: namely, the expectation that central banks will sooner or later buy these bonds for an even better price (read: for an even lower or more negative yield). The speculative fever on the bond market has no limits, but no one seems to care.

Some continue to think that the fact that 40% of all outstanding public debt in the world has negative interest rates is something completely normal and will have no negative consequences whatsoever. Unfortunately, they are wrong.

Interest Rates Are Prices Central Banks Cannot Manipulate Forever

The biggest monetary experiment in the history of the world will not end pretty. And the fact that central banks are encouraging the speculative fever on bond markets in this last phase of the longest and most extreme bull market in fixed income ever is rather embarrassing.

Central banks are not almighty. Central banks cannot keep interest rates low or negative forever without completely destroying the currency or unleashing high inflation. Chairman of the European Central Bank Mario Draghi, too, cannot make an artificial bubble, a house of cards, last forever.

Sooner or later the unintended negative consequences come to the surface.

And the unintended consequences of the ECB-policy might come to the surface rather sooner than later. Some banks began — in reaction to the negative interest rate which the ECB charges them — to not pass negative rates on to depositors, but to borrowers in the form of higher interest rates. A bank, after all, lives off the margin between the interest rates it pays to depositors and the interest rates it charges borrowers. If this phenomenon persists, then it might be the case rather ironically that the ECB lowers interest rates even further, but that it will indirectly raise interest rates that banks charge in the “real” economy.

I already discussed another possibility: at a certain point it will become clear that there is not enough collateral (financial assets) to continue ECB’s asset purchases and its QE-program. If and when we reach that point, the chaos will be unimaginable.

This Will Be the Damage When the Bubble in Bonds Bursts

Investors that have exposure to the biggest bubble in fixed income ever (and we have data on interest rates, at least in the Netherlands, since 1600) should be very worried for two reasons:

  • Lower Bond Prices

Even if interest rates only “normalize,” something the Federal Reserve at the moment pretends to do, it means that bond holders with negative (or low) yielding bonds will be faced with an enormous loss due to lower bond prices. Remember, bond prices move inversely to interest rates. Higher interest rates mean lower bond prices. Most investors are looking to losses of 35% or more when interest rates, I repeat, only “normalize” (and do not overshoot) to their historical average.
A random investment advisor of a bank will, however, tell you that this is not a risk, because you could simply hold the bond “until it matures and you’re made whole by payment of the principal.”
That this is absolute nonsense is demonstrated by three facts:

  1. First of all, this advisor is ignorant of the economic concept of “opportunity cost.” Holding a bond has an opportunity cost. If, for example, interest rates go up with 10 percentage points, then you could hold the bond until it matures, but you will without a doubt end up short on your pension.
  2. If you have put money in a government bond that matures in 30 years and you are 55 years, then you do not have the luxury of holding the bond until the bitter end, especially because interest rates are so low (or negative) that you cannot live of the income (read: the interest payments).
  3. The vast majority of investors invests in government bonds through mutual funds. If the bubble in bonds bursts, then these funds will be forced to sell bonds when bond prices are crashing, resulting in a gigantic loss for the investor. When markets crash, the herds want out and start redeeming their fund shares, forcing fund managers to liquidate their bond holdings at the worst time imaginable.
     
  • Write-downs/Bankruptcies

With the current worldwide debt levels you should definitely not count on getting back 100 pennies on the dollar. The principal you invest is at great risk. In the case of Greece, it meant for some bond holders a complete loss, the often heard “haircuts.” A majority of the sovereign bankruptcies in history ended badly: most investors that trusted their hard-earned money to the state received zero after a sovereign default. In the rosiest of scenarios, governments might demand haircuts of 30 to 50 percent of the principal and you will pay the toll.
Whereas with corporate defaults a company’s assets are sold and bond holders receive their share of the proceeds, countries do not have assets that can be liquidated. A country is creditworthy, because it can confiscate the income of its citizens. But when a country defaults, no bankruptcy procedure exists to sell off assets until bond holders recover all or at least part of the principal invested.

History is full of examples in which bond holders trusted their money to the government and lost every penny. Sovereign bonds are sometimes a false security. And as Ludwig von Mises already wrote in the 50’s:

“The financial history of the last century shows a steady increase in the amount of public indebtedness. Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract.” (Chapter 12, Human Action)

You have been warned.

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