The Smart Money

Can We Ignore the Alarm Bells the Bond Market Is Ringing?
by Neil Irwin, The New York Times
JULY 11, 2016

The stock market can rise and fall for all sorts of reasons, and sometimes for no apparent reason at all. But the bond market, where trillions of dollars change hands and long-term interest rates are determined, is steadier (normally). Its prices are generally tied closely to the outlook for growth and inflation over the years ahead.

The long-term interest rates that currently prevail across all the major advanced economies are consistent with a disastrous economic future. Taken at face value, they imply that the smart money expects inflation will remain extraordinarily low for years to come, and that growth will stay so weak that central banks won’t be able to raise rates for years. It is a shift that has accelerated since Britain’s vote to leave the European Union on June 23, but one that has been underway for years.
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Across other major advanced economies, the signals sent by bond prices are even worse. Ten-year bonds are now offering negative interest rates in Germany, Japan, Switzerland, Denmark, and as of Friday’s close, the Netherlands. That means buyers of these securities will get fewer euros, yen, Swiss francs or Danish krone back than they invested, a development without precedent in hundreds of years of financial history.
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Whatever you think of the wisdom of using government deficits to try to prop up a faltering economy, governments for the most part simply are not responding to very low interest rates and depressed economies by radically increasing deficit spending and thus increasing the supply of bonds.

So rising demand for bonds that is largely indifferent to price (even a willingness to buy the bonds at a certain loss) along with pretty much fixed supply combines to drive up prices, which in the bond market means driving down rates.

And even though the United States isn’t the prime driver of this — the Fed has ended its Q.E. program, and American debt outstanding continues to rise — the bond market is sufficiently global that it’s an important part of the story.

When German and Japanese bonds are offering negative returns, the 2 percent or so that U.S. Treasury bonds were offering earlier this year looked extremely attractive.
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The bond market right now is like a speedometer that is miscalibrated and therefore unreliable. It may be less useful than usual, and is not to be interpreted literally — but it’s still telling us something. And that something is that we should be worried about the possibility the world is in a nasty deflationary economic trap that won’t get better anytime soon.