We tend to think about house prices, stock market values, fine art, antique furniture, wine, and equities when we consider falling asset value.
How about this asset price crash? When issued less than two year ago, the March 2020 Index-Linked Gilt stock was priced around £330 per share; today, it is only £62 or less than a tenth of its original value.
It has transformed a negative yield (2.5%) into a positive yield (1.13%). Who knows what possessed the buyers of these notes to pay such a high price? It was clear that inflation was on its way even when the notes were issued.
If God didn’t want them to be sheared then he wouldn’t have created sheep. Investors had been conditioned to believe that rates would always be low because of years of ultra-low rates. They assumed that any inflation would only be temporary. The lessons are being painfully re-learned.
It is likely that the buyers were UK pension funds who planned to hold the stock until maturity to match liabilities. Therefore, it could be justified to say that, for them, volatility in price doesn’t matter.
In the past two years, Government Bonds have experienced a dramatic bear market.
The Bank of England’s “quantitative ease” asset purchase program has cost the Government a lot of money.
The taxpayer is forced to cover the losses of stocks bought at the peak of the market.
The bond market has been raging again in the last week. This is due to the belief that, even though interest rates have reached their peak, central banks will likely hold them higher than originally thought for longer.
The crash has been largely ignored by the general public.
The bond market crash was just the opposite of the larger story. As interest rates increase, asset prices drop.
The collapse of values serves as a reminder that “risk-free assets” do not exist. This idea continues to support the government bond market and is the sole reason why investors purchase them.
If you invest in a Government Bond, at least, you know it will return its face value at maturity, provided the Government does not default, which has never occurred in Britain. Germany, France, or the US, however, are not included in this list.
Inflation is the primary risk, as it is a legal backdoor default. If you are a foreign buyer, there is also the currency depreciation. Both of these factors can devalue a property just as much as price volatility.
We’ve seen this before. In the 1970s, and even in the early 1980s, generations of savers lost everything due to exposure to government bond. We saw a similar situation to a strike of buyers as inflation increased, which caused rates to rise even more.
Paul Volcker then came along with what may seem like common sense today, but was revolutionary at the time: that investors would stop purchasing government bonds if the Federal Reserve did not start setting interest rates above the inflation rate.
The Fed responded accordingly, and lo and behold inflation started to decline, sparking an almost 40-year bull run in government bonds. Governments found that they could borrow almost nothing.
With few exceptions, they did. This culminated in a flurry of new borrowings during the pandemic when central banks were ready to purchase the debt as quickly as it was issued.
It’s a constant surprise that this period of utter madness hasn’t caused more system damage. It is only now that we can see the full extent of this madness. The Liability Driven Investment Crisis of Liz Truss’s short-lived Premiership and the collapse Silicon Valley Bank, in which deposits were invested in devaluing US Treasury bonds, are two of the most obvious examples.
Other cases like this must also be lurking in the shadows, especially in the banking sector. You’d probably expect more carnage to follow a major correction. Klaas Knot, a Financial Stability Board member, recently began an investigation into potential vulnerabilities. However it could be too late.
Now, let’s get to the $64 trillion. Has the bond market crash now reached its climax? Answer depends on future inflation trajectory.
The markets continue to bet heavily that there will be a “soft landing” or a gradual reduction of inflation to the target, but without an increase in unemployment or a reduction in output.
This has rarely happened in the past. The central banks almost always over tighten and collapse the economy.
The job market is still booming, but it is not the same as before. The US jobs market is still booming, despite recent signs that it has slowed down in Britain and Europe.
Oil prices have also started to rise again, sparking fears about another winter energy shortage. It is still not clear whether the inflationary dragon will be slain.
If interest rates are indeed at a plateau, it is also possible that government bond prices have reached a bottom and may even offer resale value.
Bond prices usually begin to rise around three to four months after the official policy rate reaches its peak. We are not yet certain that we have reached the peak. The central banks keep the markets guessing. Is it the end or just a breather?
The world’s governments and bond investors will pray that it is not the latter. That could be the best bet.
Don’t expect the world to be like it was. Remember the Volcker Rule. The only way to guarantee price stability is for interest rates to be higher than inflation. Normality is not zero-interest-rate environment from the decade before the pandemic.