Bonds, interest rates and the risk of a crash

A speech yesterday by Guy Debelle, the Australian Reserve Bank's Assistant Governor (Financial Markets) dealt with a problem that has been worrying me.


This graph shows the yield on Commonwealth Government bonds. They are now at the lowest levels in history. However, they still offer a tiny positive return. That is not true in many places, with some Government securities providing negative nominal interest returns. In buying them, you lock in a guaranteed loss.

Even where yields are positive, they are now so low that  investors are getting little or no compensation for term risk or the risk of inflation.

Two factors appear to be at work. The first is that banks in particular are being required to hold a greater volume of Government securities as part of the post GFC reforms of the global financial sector. At the same time, the global supply of Government securities has been reduced in part because of action to reduce budget deficits, in part because quantitative easing has been hoovering up the supply of bonds, transferring ownership to central banks. The banks must hold Government securities, so they have been chasing a diminishing supply, bidding up prices.

You can see the flow-on effects. In the case of retirees, for example, it is now very difficult to find a secure investment offering a meaningful positive return. People respond by eating into their capital or by chasing those assets that still offer possible returns, bidding up prices there. You can see the flow on effects, too, in the bidding by bodies such as pension funds for existing infrastructure assets that hold out the potential for a higher yield.

The present position is unsustainable. Interest rates will rise. But the unwinding process could well be very messy.As a simple example, requiring banks to hold certain classes of securities for liquidity and safety purposes when the marketplace for those securities has become distorted of itself creates new systemic risks.

Sadly, the defects in my crystal ball make sensible prognostications difficult. My best guess (hope?) is that we will muddle through, but I am far from sure at the moment as to how this might happen. The alternative is another economic crash.     .