Bond yields start to go back to the future as stimulus policies unwind

The UK has the longest-running history for government bond yields, going back to 1703. Over the centuries, lots of strange things have happened including World Wars, Depressions and Revolutions.

But as the chart shows, the last 20 years have been very strange. It shows “real yields” – the interest rate less the inflation rate – in 50-year periods (23 years since 2000):

  • In the 1700s, the maximum rate reached 34% and the minimum rate -18%
  • In the 1800s, the maximum rate was 27% and the minimum was -32%
  • In the 1900s, the maximum rate was 18% and the minimum was -21%
  • Since 2000, the maximum has been just 4% and the minimum has been -7%

In other words, the “real rate” has sometimes been very positive – and sometimes very negative. But overall, it has consistently averaged 2.5% above inflation.

But as John Stepek notes for Bloomberg, something very strange has been happening since 2009 as the chart shows:

“The thing that strikes me most is that the last 15 years have been very, very unusual. Don’t get me wrong. There’s a lot of ups and downs in this chart.

“The 1970s and 1980s are pretty spiky and weird too. But you couldn’t describe the last 15 years as ‘normal’.”

The reason is the vast stimulus packages launched by the central banks since 2003. They began in the run-up to 2008’s subprime crisis, as the chart shows.

And then they took off exponentially, to total $73.5tn by Q1 this year. This meant that interest rates were not only close to zero. They were also usually below the rate of inflation:

  • China’s stimulus has essentially been ‘subprime on steroids’ reaching $50.5tn by Q1 this year
  • The US, Eurozone and Japan have been next in line, printing $8.5tn, $7.1tn and $5.4tn
  • The UK and Switzerland did $1tn and $0.9tn, adding to the pot of virtually free money

But last year, something even stranger happened. The central banks suddenly realised all their computer models were wrong.

The models were suggesting inflation was “transitory”  But in fact, it was out of control

As the chart shows, UK inflation (red line) is now well above the 10-year rate (blue line), and looks set to stay there for a while.

Of course, the UK is somewhat of a ‘special case’. Brexit, and premiers Johnson/Truss, have created major problems for the economy.

But extreme cases help to highlight core issues. In the case of the stimulus programmes, they created a liquidity boom which took house prices and stock markets to unsustainable levels.

Even worse, the programmes have lasted for a very long time.  A whole generation has been led to believe interest rates will always stay low.

Many homeowners and traders sincerely believe that interest rates are “normally” around 0% – 1%. And they have no idea that interest rates averaged 2.5% above inflation until the stimulus programmes began.

In other words, central banks have completely distorted developments in financial markets since 2009.

Even worse, they have created $73.5tn of debt in the process:

  • The key feature of debt is that it brings forward demand from the future
  • And, of course, demand is already reducing due to today’s demographic deficit
  • As the chart shows, the Perennials 55+ generation are now the main source of population growth

And whilst the Perennials are lovely people, they don’t contribute much to demand. They already own most of what they need, and their incomes usually reduce when they retire.

The central banks have spent the past 15 years telling us that debt and demographics “don’t matter”. They claimed they could always create demand via stimulus.

But now the policy has run out of road. The homeowners and stock traders who believed them will likely be the ones to suffer as real rates return to normal levels.