During the past years, government bond markets have been trading at valuations that would normally be classified as a bubble. Regardless of this, government bonds have continued their relentless rally, with as a result that they are now trading at completely ludicrous valuations. Since a picture is worth a thousand words, I have decided to use the following 5 charts to visualize the insanity of the government bond bubble.
#1: US Long-term real yields
As of the moment this article was written, 10 year US Treasuries yield only 1,675%, while US CPI inflation was running at 0.8% in December 2014. This means that an investor, who loans the US government his money for 10 years, will only make 0.875% a year in inflation adjusted profits. Figure 1 illustrates just how incredibly low the inflation-adjusted return (a.k.a. real yield) of 10 year US Treasuries is. Currently, real US yields are lower than during World War II and the Vietnam War.
Figure 1: US real yields since 1919 (Source: Credit Suisse)
#2: Negative yields in Europe
If you thought things where bad in the United States, the situation in Europe will make you think that you are in the Twilight Zone. As of January 23rd 2015, around €1.4 trillion of Euro area government bonds are trading with negative nominal yields (Figure 2). According to a Bloomberg article, the total size of Europe’s sovereign bond market is roughly €8 trillion. This means that over 17.5% of European government bonds are considered so “safe”, that one has to pay for the privilege of lending money to Northern European countries.
Figure 2: Total amount of Euro area sovereign bonds trading at negative interest rates (Source: JP Morgan)
#3: Equities are yielding more than bonds
Currently, close to 51% of the companies in the US S&P500 trade with a dividend yield above the 10 year US Treasury note (Figure 3). This is a remarkable situation which has not been seen since 1957. As one has come to expect, the situation in Europe is even more extreme, as Eurozone bonds have never traded at a more expensive valuation versus European equities at any time in history (Figure 3). This is incredible, as these relative valuations in Europe surpass levels witnessed during the Great Depression or World War II.
Figure 3: Relative valuation of US and Eurozone equities versus government bonds (Source: RBC Capital and Fidelity Worldwide Investment)
No article about bond bubbles would be complete without mentioning the situation in Japan. The land of the rising sun is the ultimate example of just how extreme bond market valuations can become. Basic investment principles dictate that investors in bonds should receive an interest rate which is adequate for the risk they are taking by lending a third party their money. Thus, one would expect investors would demand high interest rates to compensate for the risk of lending money to a country that has a debt-to-GDP level of 250% and budget deficits as far as the eye can see. However, these principles do not apply to Japan, as the country’s 10 year bond yield trades at only 0.28% (Figure 4). With Japan’s government debt at such high levels, it is almost certain that investors in Japanese government bonds will suffer losses in real-inflation adjusted terms.
Figure 4: Japan 10 year government bond yield since 1984 (Source: Trading Economics)
#5: Investors are still buying more bonds than equities
Even though bonds are trading at such insane valuations in both absolute and relative terms, investors continue to pile into bonds. Since the financial crisis of 2008, almost all investment inflows have gone into bonds. Compared with the long-term historical asset allocation flows, investors have an enormous $840 billion overweight position in bonds (Figure 5). The very fact that highly educated investors have the largest relative overweight position in bonds in this day and age, is a testament to the shocking size the current bond bubble has reached.
Figure 5: Cumulative flows into bond and equity funds (Source: Deutsche Bank)
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Simon is the CEO and Editor-in-Chief of Foresight Investor. He has been following the markets passionately for over 7 years.