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Bond investors have recently faced challenges and uncertainties. This raises questions about why government bonds are still considered safe and risk-free compared to equities, as claimed by economists and professional investors.
The criticism against government IOUs is significant. For example, the US treasury market, known for its safety, had a return of minus 17.8% in 2022, slightly better than the minus 18.0% return on stocks in the S&P 500 index. The difference is negligible, indicating that bonds do not provide diversification relative to equities. Bonds and equities both carry risks, albeit with nuanced distinctions.
In 2023, US equities have outperformed bonds. However, this performance is somewhat illusory, as it is mainly driven by the seven largest technology companies. This turnaround contradicts the conventional wisdom at the beginning of the year that rising interest rates would diminish the present value of tech companies’ future income streams.
Artificial intelligence (AI) has played a significant role in this contradictory scenario. The enthusiasm for AI resembles the market euphoria during the dotcom bubble. Despite concerns about a recession, fears have subsided.
Regarding bonds, the long-running bull market that began in the 1980s is clearly over. Recent unease can be attributed to various factors, including the Fitch rating agency’s downgrade of US treasuries, concerns about persistent budget deficits, and the withdrawal of Japanese capital from the US due to the Bank of Japan’s policy changes.
William White, former head of the monetary and economic department of the Bank for International Settlements, argues that the world is transitioning from an era of abundance to an era of scarcity. Trends such as global supply chain expansions, workforce growth, trade surpassing GDP growth, and reduced military spending and government expenditures are reversing.
Additionally, energy supply is limited due to climate change and security concerns. Record levels of private and public debt further impede policy options and economic growth. These factors indicate a more inflationary world, with greater volatility in inflation and interest rates.
White predicts lasting inflationary pressures and higher real interest rates, contrary to popular expectations. If he is correct, the bond market’s potential to cause financial instability should be carefully considered.
Phoney peace has prevailed in the US since the collapse of Silicon Valley Bank and other regional banks in March. However, the US Federal Deposit Insurance Corporation estimates that unrealized losses on American banks’ securities amounted to $515.5bn at the end of March, equivalent to 23% of the banks’ capital. This poses a significant challenge, especially with a looming commercial real estate disaster on the horizon.
Central banks are also facing balance sheet damage due to rising bond yields resulting from their asset purchasing programs. As of March 31st, the Federal Reserve’s mark-to-market losses on securities reached $911bn, nearly 22 times its capital of $42bn.
One may wonder how the dollar can remain the world’s primary reserve currency if it is backed by an insolvent central bank. The answer lies in seigniorage, the profit from manufacturing money, which is not reflected on the balance sheet. Central banks have the ability to print money to alleviate trouble, but this has limits. As history has shown, markets may lose confidence in a central bank’s credibility.
Although the US has not reached that point yet, there are currently no viable alternatives to the dollar and US treasuries. For investors, the paradoxical message for now is that while bonds are unsafe and risky, they offer higher yields compared to central banks’ inflation targets of around 2%. The financial world is nothing if not full of contradictions.
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