For a long time it has often been assumed that government bonds of developed countries are a safe investment. Whenever there has been a stock market correction, one always benefited by holding government bonds. Especially if they had a decent yield and it was above the rate of inflation. The difference now is that before the current market crash towards the end of February, interest rates in most developed countries were already at very low levels. Yet as the crash unfolded both the Bank of England (BoE) and the Federal Reserve (Fed) reduced interest rates even more to stimulate the economy. As I write this article, the current BoE rate is just 0.1% and the Fed rate is at 0%. Since 2016, the European Central Bank (ECB) interest rate has remained unchanged at 0% and so far there has been no plan to drop it down further towards negative territory, yet that could easily change in the coming weeks or months if the current crisis exacerbated by the Coronavirus pandemic shows no signs of improving.
The current yields on ten year government bonds in the following countries are just 0.8% in the USA, 0.39% in the UK, 0.02% in Japan, and in some countries such as France and Germany they are already negative at -0.03% and -0.37% respectively. For those bonds to increase in value these already pitifully low yields would have to fall even further. By investing in bonds with negative yields, you are essentially paying for the privilege of holding the bonds. And I have always wondered what would make one invest in bonds with negative yields?
In the case of Germany, if one had a lot of cash which they didn’t want to invest in other securities or deposit in a bank account, they would invest it in those negative -0.37% yielding government bonds. They may be too scared to deposit it all in a bank, which is financially not in great shape and may even be faced with the very real risk of going under Lehman Brothers style. The two main German banks, Deutsche Bank and Commerzbank, are both currently not in great shape financially and may need a bailout to save them. If a bank goes under, your money in a bank is safe up to a certain threshold and if you have savings deposits, which exceed the threshold amount, you will likely lose the entire excess amount if the bank goes bust. In contrast to other Eurozone (EZ) countries, Germany is in better shape than many other EZ countries. Furthermore, it’s national central bank, the Bundesbank, is running a massive surplus against the national central banks of most of the other EZ countries.
Unlike Germany, the yields on the ten year government bonds for Italy and Greece are positive at 1.21% and 1.43% respectively. Yet both countries have enormous and unsustainable levels of debt and are thus at a much higher risk of default. As I explained in some of my previous articles, I continue to remain of the view that it is becoming increasingly likely that the Eurozone will not last and that all Eurozone countries will revert to their own currencies. If this were to happen, it is highly probable that within the EZ area, there will be a huge flight of money to those countries such as Germany who will be least affected by any great devaluations of their new currencies. For example, the New Mark is likely to strengthen in value whereas the New Lira or New Drachma is likely to fall in value quite sharply against the new currencies of other stronger former EZ countries. Thus within the framework of the entire EZ, negative yielding German bonds are probably one of the safest securities to invest your Euros into despite the fact they come with a price. If the EZ falls apart and most EZ banks go under, those negative yielding German bonds will immediately be denominated into strongly valued New Marks. By contrast, those positively yielding Italian and Greek bonds will be converted into new weaker currencies.
In spite of all this, I think government bonds are overall very expensive where their risks vastly outnumber their rewards. Of course, their low yields reflect the low interest rates of their countries. However, if one were to look at the chart of the yields of ten year UK and US bonds over a 40 year period, it is clear they’ve been in a huge bubble for the duration of this time frame. In September 1981, the yield on 10 year US treasury bonds was over 15% and in that same year in October, the yield on 10 year UK gilts was over 16%. Yet since that time, the yields on both bonds has been in a downward trend and currently they both yield less than 1%. Some are predicting that the interest rates of both countries will fall into negative territory and therefore the yields of both bonds will also be negative suggesting that if one were to buy such bonds even with their extremely low yield, the yield may get even lower.
An unpopular opinion I hold, which many don’t share, is the real risk of dramatic and unexpected inflation. Many are predicting a long period of negative interest rates and deflation, but I am not so sure. What concerns me greatly is the huge amount of debt in many countries. Much of this debt is a result of an unusually long period of low interest rates. Since the middle of the last financial crisis in 2008, total levels of global debt have increased over 50%. And now with the current new crisis triggered by the coronavirus pandemic, this already staggering level of global debt is only going to get bigger as national governments plan huge rescue packages to prop up vulnerable businesses and households. In the USA, the Trump government is planning a $2tn stimulus package. In the past years since the 2008 financial crisis, large rounds of Quantitative Easing (QE) haven’t had too much of an affect on inflation. However this time it could well be different as the amounts of money printing rounds that national central banks will embark on could easily result in a great spike in inflation. This is very worrying as not only will this lead to central banks massively raising interest rates to tame this inflation, it will also make all outstanding government, corporate and household debt much more expensive to service. It is for those reasons that I think buying so called safe government bonds at current yields is a much more risky exercise than many realise. Furthermore, as all those big accumulated existing debts become more expensive to service with rising interest rates, there will be lots more defaults which in turn will weaken the purchasing power of the currencies of major economies including the USA.
All these concerns naturally make me more attracted to precious metals like gold and silver, which, as tangible forms of insurance, will increase in value as the purchasing power of major currencies like the dollar and the euro declines. As precious metals are commodities, it is hard to predict their price movements. Yet if like me, you believe that they are a viable hedge against a world that is increasingly becoming smothered in debt, you will realise that there is quite a compelling case to owning some precious metals as a form of insurance against these economic vulnerabilities. Precious metals are the new safe havens rather than government bonds.
By Nicholas Peart
30th March 2019
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