Sat, Jul 05, 2003 - Page 9 News List

When will the bond-market bubble burst?

Judging by the price of long-term bonds, investors appear to mistakenly believe that the downward trend in inflation is likely to continue

By Robert Shiller

Unless inflation drops much more, now is an ideal time to be a borrower and a bad time to be a lender or investor in long-term bonds. Indeed, in many countries, exaggerated fears of deflation are keeping interest rates depressed and the cost of capital at historic lows.

The lowest rates were seen on June 13. Ten-year bonds in the US yielded 3.11 percent, not much above the 2.1 percent inflation rate of the past 12 months. Ten-year government bonds in the Euro-area yielded 3.54 percent, while the Euro-area inflation rate was 1.9 percent. The yield in the UK was 3.86 percent, while inflation was 3 percent, and Japanese bonds yielded 0.44 percent, compared with inflation of -0.1 percent.

In each case, a small increase in today's very low inflation rates would eliminate any real gain from investing in bonds. If low long-term rates do not hold, long-term bond prices will drop sharply, leaving investors with a loss.

The history of developed-country bond markets in the past half-century is relatively straightforward. Consumer inflation increased fairly steadily (albeit with major short-run swings), until the oil crises of 1973 to 1974 and 1979 to 1981 propelled it to historic highs in Europe, North America, Japan and other countries. Afterwards, the trend was reversed, and inflation declined fairly steadily.

The oil crises marked a political as well as an economic turning point. Until that time, central banks, fearing recession, were gradually losing their grip on inflation. But public anger over sky-high price growth precipitated by the oil crises finally allowed central banks to tighten credit and smother inflation with massive global recessions. Corporate managers, meanwhile, got the public support needed to resist many cost-of-living allowances that were fueling a wage-price spiral.

The general investing public never really understood these trends. They did not comprehend the upward trend in prices before 1980, so bond yields, lagging behind rising inflation, were too low. In the US, 10-year US Treasury yields averaged only 1.46 percent above the inflation rate between 1953, when annual average inflation was only 0.63 percent, and March 1980, when inflation peaked at 14.66 percent.

Nor did the investing public fully comprehend the downtrend in inflation after 1980, so long-term bond yields, lagging behind falling inflation, were too high. In the US, yields on 10-year Treasuries have averaged 4.14 percent above the rate of inflation throughout the period of declining inflation that began in April 1980.

The public's failure to recognize inflation trends meant that long-term bonds were a terrible investment until 1980, when inflation was only a little lower than yields, and a lucrative investment thereafter, when declining inflation and high yields guaranteed large real gains.

Investors are again making the mistake of pricing bonds in expectation that the downward trend of inflation will continue into deflationary territory. Indeed, today's low long-term rates suggest that investors are projecting the downward trend to continue over the next 10 years at the same pace that it has done since 1980, implying that the current US inflation rate of 2.1 percent would fall to zero or below by 2013.

Is this reasonable?

Almost certainly not. No central bank would permit deflation for long, and the current level of inflation probably represents the lower boundary that most monetary authorities consider acceptable. At the same time, there is no such clear upper bound to inflation. So with inflation rates near their long-term lower bound, the expectation should be for higher, not lower, inflation rates over the longer term.

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