The conditions for the greatest bond bull market in modern history were set in the 1970s, when inflation hit runaway levels. Central banks, led by the US Federal Reserve, launched a draconian response, pushing interest rates sky-high. Over the 40 deflationary years to the end of 2021, the annualised real return on bonds in the world bond index was 6.3 per cent, not far short of the 7.4 per cent return on global equities over the same period. 

So says the invaluable Credit Suisse Global Investment Returns Yearbook prepared by economists Elroy Dimson, Paul Marsh and Mike Staunton. As today’s central bankers doggedly pursue interest rate policies dubbed “higher for longer”, many investors have taken a bet, so far unrewarding, on history repeating itself.

Yet it is important to bear in mind that the equity-like returns on government bonds in this golden period were a mixed blessing for investors. Moreover, this spectacular 40-year run created a new mythology of bond investing, along with a perversely misleading vocabulary. 

Academic economists and actuarial consultants declared government bonds were “safe” assets that delivered a risk-free interest rate. They also claimed that bonds offered diversification against risky equities, an argument that provided the rationale for the hallowed 60/40 portfolio split between equities and bonds.

But in much of the developed world the yield on many government bonds before 2022 was negative in both nominal and real terms, which is a curious kind of risk-free rate. Such bonds offered the certainty to investors of a guaranteed loss on maturity. As for safety, global bonds offered a real return in 2022 of minus 27 per cent, with UK gilts performing even worse than that. The reality is that nothing in capital markets is ever risk-free. 

Line chart of 25-year index-linked gilt yield (%) showing Yields on longer-dated index-linked gilts have been negative for most of the last decade

This collision of myth with reality has serious implications not only for governments and regulators. It affects individual investors, who are contemplating how they should respond to the new landscape of bonds; the UK’s fixed-term mortgage borrowers, whose home loan rates are heavily influenced by the path of gilt yields; and pension savers looking to reduce the volatility in their pension investments as they approach retirement.

The illusion of protection

Paradoxically, investors in longer-dated index-linked bonds last year saw their investment decline by one-third or more in value on a mark-to-market basis.

Many bought on the erroneous assumption that they were acquiring protection against rising inflation. Yet the protection only operates if the index-linked bond is held to maturity. In fact index-linked gilt prices are driven by relative real yields, not inflation. So if nominal gilt yields rise, index-linked gilt yields have to rise to offer a competitive return, which destroys capital value regardless of what is happening to the general price level, since rising yields mean falling prices.

This is particularly disastrous for people in UK defined contribution pension schemes where the great majority take a default option that involves switching into supposedly safe assets such as fixed interest and index-linked gilts as retirement approaches. Investment consultants call this process “de-risking”, a phrase of outrageous terminological inexactitude (to borrow Churchill’s memorable coinage). Such switching exposed people to big capital losses.   

To make matters worse, bond prices fell in tandem with equities in 2022. So much for diversification. Earlier equity-like returns came with equity-like volatility.

The good news today is that bonds no longer offer terrible value as they did before 2022. But do not expect them to deliver anything like the return of the 40-year golden age. While central bankers tend to attribute low inflation during this period to their sagacity, the real driver of disinflation was globalisation. 

The global labour market shock resulting from China and eastern European countries joining the global trading system eroded the bargaining power of labour in the developed world. Increasingly complex cross-border supply chains added further disinflationary impetus.

This has now gone into reverse due to the Russian invasion of Ukraine and geopolitical friction between China and the West. At the same time, stagnant real incomes in advanced countries, resulting from global labour market pressure, have spawned populist politics and a retreat into protectionism. And as academics Manoj Pradhan and Charles Goodhart have argued in a recent book the ageing of populations in the developed world will cause labour markets to shrink, so re-empowering workers. How, then, given these renewed inflationary pressures, can a case be made for a bond bull market?

An uncertain outlook

One obvious starting point is that if you believe central banks will ultimately bring inflation down close to their targets of around 2 per cent then current yields of 4 to 5 per cent on UK gilts and US Treasuries represent good value, especially relative to equities, where earnings estimates look unduly optimistic in the US and, perhaps also, the UK.

There is, in addition, a serious possibility of monetary overkill. Central bankers are steering policy using backward-looking data. In the US, the UK and the eurozone they are not much interested in forecasting the money supply. The reason is that soon after monetarism became fashionable in the 1980s the correlation between broad money and consumer price inflation had broken down.

Chris Watling, chief executive at research company Longview Economics, sees the breakdown as a consequence of financialisation. That is, most newly created money since governments started to deregulate finance in the early 1980s fed into asset prices rather than goods and services in the real economy. A notable example of this was the growth of mortgage debt which has gone from around 10-20 per cent of gross domestic product to more than 100 per cent in many countries. In the UK it peaked at just short of 80 per cent in 2010.

More recently, money creation since the 2007-09 financial crisis has been driven by the central banks’ asset purchasing programmes, known as quantitative easing. This, too, has gone into asset price inflation, mainly in government bond markets.

Watling argues that this pattern has now been broken and that the latest bout of inflation stems from money creation during the pandemic going into households’ and businesses’ bank accounts in the form of emergency grants, furlough payments and other support. This was then spent, leading to old-style inflation, in which too much money chased too few goods and services.

Lending support to the argument is the fact that monetarist economists such as Tim Congdon in the UK and Steve Hanke in the US were making prescient forecasts about an inflationary surge back in 2021 when central bankers, relying on complex but unhelpful economic models with no money supply input, were declaring that inflation would be transient. 

Both economists are now forecasting incipient recession in the light of the contraction in broad money in the US and the eurozone and very low money growth in the UK, where banks are adjusting their balance sheets in line with tougher capital requirements.

Line chart of Broad money (M3) as a % of GDP showing Ratios of money to GDP are declining fast

So far the falls in real money balances have not done too much damage, according to Congdon, because they have only offset the overhang of money from excessive monetary growth in 2020 and 2021. But ratios of money to GDP are declining fast.

Recession brings the risk of deflation which is, of course, good for bonds as weak demand in the economy causes interest rates to fall and bond prices to rise. The recent weakness of commodity prices further highlights the potential in the short term for deflation.

The case against

What are the counterarguments to bond bulls? The first might be the enormous uncertainty surrounding the outcome of the monetary experiment conducted by central banks since the financial crisis. Having expanded their balance sheets hugely they are now keen to shrink them in the interests of preserving their anti-inflationary credentials — a process known as quantitative tightening. This is uncharted territory in monetary policy. The big question is, with central banks selling, who will buy government IOUs at a time of great public spending pressure?

Apart from the increase in spending because of the pandemic there will be big demands on the public purse not only for a continuing rise in healthcare bills but for infrastructure investment in the transition to low carbon. Ageing populations mean bigger pension bills. The war in Ukraine and wider geopolitical friction make higher defence spending necessary.

This is happening against the background of a pressing increase in global indebtedness. The Institute of International Finance, a trade body, estimates that global debt at $305tn is now $45tn higher than its pre-pandemic level. In the UK public sector net debt stood at 100.1 per cent of GDP in May, topping 100 per cent for the first time in 62 years.  

This raises questions about the potential conflict between central banks’ objectives — price stability and financial stability. Higher for longer means many households and corporations will be at greater risk of default. That in turn is potentially destabilising for the banking system. So, too, is the fall in bond prices as monetary policy has tightened. 

The bonds in bank balance sheets have fallen in value. This has tilted some regional banks in the US such as Silicon Valley Bank into insolvency. The same could happen in Europe, especially on the continent, where banks have often been pressed into holding large quantities of their governments’ paper.

A particular difficulty arises because of the migration of risk from the conventional banking system to the dangerously opaque non-bank financial sector. It is difficult for financial regulators to keep track of the related risks.

An indication of this came with the liquidity crisis in the UK gilt market last autumn, in the wake of a Budget under Liz Truss’s government that wrongfooted many pension funds which pursued so-called “liability driven investment strategies”. They were unable to meet calls for more collateral as gilt yields rose and prices fell. The Bank of England moved swiftly to act as a last resort buyer of long-dated gilts and postponed quantitative tightening, thereby forestalling a potentially systemic financial collapse. But will future crises in the non-bank financial area be so swiftly and readily managed?

This is a world in which financial stability may take priority over inflation fighting. Indeed, some economists argue that it should. Willem Buiter, former chief economist of Citigroup and a former member of the Bank of England’s monetary policy committee, believes financial stability has to come first because it is a precondition for the effective pursuit of price stability. That would not be good news for bond investors in the short term, since loosening policy to address financial instability reopens the possibility of inflation through money creation.

Will central banks keep calm and carry on? 

Above all there is a question whether central banks will hold their nerve if they confront political pressures when overborrowed companies and homeowners plunge into default in a recession. Their much-vaunted independence will be at risk. That highlights the existence of another potential conflict in central banks’ objectives — that between inflation fighting and career risk. Politicians rarely thank central bankers for curbing inflation if it comes at the cost of higher unemployment. The logic of inflicting a short, shallow recession to avoid having a longer, deeper one later has no purchase in the political market place.

Policymakers are also conscious that inflation is actually a solution to outsized public sector debt at levels that have hitherto only been seen in wartime. The key to reducing wartime debt has always been a combination of economic growth, fiscal restraint (meaning austerity), artificial restraints on interest rates (known as financial repression) or surprise inflation. That said, we are in a much lower growth world than in the three decades after 1945 and financial repression is harder to pull off now that capital flows across national borders.  

It is not hard to envisage circumstances in which central banks choose to stretch out the period over which they seek to return inflation to target, so facilitating a reduction in the real value of the debt. Or, again, governments could raise inflation targets, say, to three per cent while arguing that this is more realistic given the structurally higher inflation that we face in the 2020s.

But this option would only be available in countries where monetary policy is perceived to have been effective. The Bank of England’s much poorer performance on inflation control when compared with the Federal Reserve and the European Central Bank has so damaged its credibility that a move to a higher target might cause market turmoil.

A final difficulty with the bullish case for bonds is simply that it might take higher policy rates than the market now anticipates to curb the second-round effects of inflation in labour and other markets as people try to recoup income that has badly shrunk in real terms. This distributional struggle could last longer than generally expected. And in financial markets there always lurk what Donald Rumsfeld, when US Secretary of Defense, called unknown unknowns.

If investors believe that it will take a recession to bring inflation back to target, then it makes sense for them to allocate more money to bonds. Some may feel gold is a better option in current circumstances where inflation is proving more sticky than expected. Yet gold is a bet on monetary policy failure. If you believe central banks will fulfil their anti-inflationary mission, the opportunity cost of holding the yellow metal that yields no income when interest rates are rising is unacceptably high.

The hope must be that the central banks achieve a smooth reconciliation between financial stability and price stability. Resorting once again to the liquidity tap when markets take the next big tumble will simply propel the debt mountain higher through another morally hazardous reduction in borrowing costs. That way lies potentially uncontrollable inflationary consequences, resulting in more populist politics and wholesale destruction of savings.

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