Alasdair Macleod – 6 February 2015

Today’s obvious mispricing of sovereign bonds is a bonanza for spending politicians and allows over-leveraged banks to build up their capital. This mispricing has gone so far that negative interest rates have become common: in Denmark, where the central bank persists in holding the krona peg to a weakening euro, it is reported that even some mortgage rates have gone negative, and high quality corporate bonds such as a recent Nestlé euro bond issue are also flirting with negative yields.

The most identifiable reason for this distortion of free markets is bank regulation. Under the Basel 3 rules, a bank with sovereign debt on its balance sheet is regarded by bank regulators as owning a risk-free asset. Unsurprisingly, banks are encouraged by this to invest in sovereign debt in preference to anything else. This leads to the self-fulfilling second reason: falling yields. Central bank intervention in the bond markets through quantitative easing and commercial bank buying leads to higher bond prices, which in turn give the banks enormous profits. It is a process that the banks wish would go on for ever, but logic says it doesn’t.

Don’t think that there is an economic justification for negative bond yields: there isn’t. Even if price inflation goes negative, interest rates in a free market will always remain positive. The reason for this cast-iron rule is interest rates are an expression of time-preference. Time preference is the solid reason that possession of money today is more valuable than a promise to give it to you at some time in the future. The future value of money must always be at a discount to cash-in-the-hand, or put the other way, to balance the value of cash today with cash tomorrow always requires a supplementary payment of interest. That is always true so long as interest rates are set by genuine market factors and not set by a market-monopolising central bank, and then distorted by banking regulations.

So we have arrived close to the logical end-point in falling yields, and in some cases we have gone beyond it. We must also conclude that negative yields are a signal that bond prices are so over-blown that they are vulnerable to a substantial correction. Furthermore, when the tide turns against bond markets the downside could be considerable. The long-term real yield on high quality government bonds has historically tended to average about three per cent, which implies that sovereign bonds would crash if central banks lost control of the market.

Bond bulls are on weak ground from another angle. If history tells us that real yields of three per cent are the norm, has government creditworthiness changed for the better, justifying a lower yield? Well, no: the accumulation of debt across all welfare economies is less sustainable than at any time in the past, and demographics, the number of retirees relative to those in work and paying taxes, are rapidly making the situation far worse.

Macroeconomists will probably claim that so long as central banks can continue to manage the quantity of money sloshing about in financial markets they can keep bond prices up. But this is valid only so long as markets believe this to be true. Put another way central banks have to continue fooling all of the people all of the time, which as we all know is impossible.