The flight to “quality” allied to aggressive interest rate cutting by the Bank of England has taken bond yields down to unusually low levels. Today you could get 1% for lending to the government for one year, just over 2% a year for lending to them for 3 years and a little over 3% for ten years. Why would you want to do that?
The optimists about government bonds say that people are going to have to buy them. Cash on deposit will yield next to nothing if rates fall further. If we go into slump and stay there, and if price increases drop away, perhaps to the point where prices start falling, then bonds yielding 2-3% are a good bet.
So what could go wrong for the bond bulls? Governments could succeed in generating recovery sooner than they think. As economies pull out of the nosedive so interest rates would have to start going up again, and inflation could resume. Governments like the UK may hurl so much more money at the problem, ballooning the Bank’s balance sheet, printing notes and other wise expanding the money supply that they will start to generate inflation.
A bubble is when an asset class moves outside its normal price range and values, only later to fall back to earth. A few months ago many told us oil had to keep on going up above the $140 a barrel it had reached, because the Chinese needed so much of it. Today bond bulls tells us bond yields will have to go down, because they are the only safe investment in a world of very low and falling interest rates and plunging inflation.
They should remember there remains a very big seller of bonds out there. The UK government is planning two bumper years of bond issue in a row. You need to take your own investment advice, but anyone should ask themselves has the world really changed so fundamentally that lending to the UK government at 1% or 2% is a great deal? Will the market willingly lend as much as the government wants to borrow whilst paying ever higher prices for the bonds? At some point in the future people might be surprised that lending to the UK government at 1% was thought to be a good deal for the saver.