By John Plender

 

Published: January 7 2009 08:00 | Last updated: January 7 2009 08:00

 

With US Treasury bills yielding little or nothing and government bond
yields plunging everywhere as central banks creep towards a
Japanese-style zero interest rate policy (Zirp), there is talk of a
government bond bubble. But is it possible to have a bubble in the
most boring form of IOU?

When it comes to aerated finance the best authority is Charles
Kindleberger, the economic historian who devoted much of his life to
studying manias, panics and crashes. His basic definition of a bubble
was "an upward price movement over an extended range that then
implodes". Speculation was an essential part of a story in which
investors were buying not for income and capital gain, but with a view
to re-selling on a short-term basis to someone else at a higher price
- a phenomenon sometimes known as the "Greater Fool Theory".

The spread of euphoria - a term coined by the economist Hyman Minsky -
then served to bring in a broader group of greedy folk with
questionable understanding of the processes involved.

Since no implosion has yet taken place, although yields have risen in
the past few days, a definitive verdict on the alleged bubble in
Treasuries is premature. Yet greed for speculative profit is surely
not what the government bond rush is all about. Still less is there
irrational euphoria in this market.

I share the view of Michael Lewitt, of Harch Capital Management, who
argues that the last thing investors are thinking when they buy zero
per cent Treasuries is reselling them at a profit. In most cases, they
expect to resell at a loss. Rather, he argues, their priority is
absolute safety and the knowledge that there will always be buyers for
securities backed by the US government. Such behaviour, then, is a
perfectly rational response to extreme uncertainty and the fear of
deflation.

Even if this is not a bubble - and some readers may regard the issue
as purely semantic - the government bond markets remain potentially
dangerous for investors. Yet that does not mean that yields will not
fall further. As long as the banking system is incapable of doing the
basic job of financial intermediation and it remains difficult to
price much of the paper thrown up in the credit bubble, governments
face no competition for funds in the debt markets. Fear will ensure
that the demand for poor-value government bonds holds up.

The risk, as I suggested here before Christmas, is that the upwards
yield adjustment could be savage when Humpty Dumpty is put back on the
wall and normal private sector financial service resumes. Given the
enormous funding pressure that will exist in the early days of the
Obama administration, and the potential shift of investment focus from
deflation to inflation, Treasuries will at some point become an
outcast asset category. The tricky question is, "when?".

For governments, the risk is different. Zirp is a wonderful palliative
that allows them to take on more debt without significantly increasing
debt service costs. That makes it too easy to move into structural
fiscal deficit. Fiscal policy also becomes highly leveraged, so that
when investors' perceptions change, the speed of deterioration in the
fiscal balance is cruel.

Great discipline is thus required to ensure that increased public
spending and reduced taxes can be readily reversed when the
deflationary threat retreats. Such discipline does not come easily.
And the sheer size of the Obama administration's fiscal commitments is
already daunting.

Its long-term plans for healthcare will steer the US closer to a
continental European model of social market capitalism, which does not
come cheap. And its short-term plans, notably in relation to the
financial and motor sectors, will take the US into territory oddly
similar to that of Mussolini's Italy.

It seems unlikely a low or zero interest regime in the US will last
anything like as long as in Japan, given the policy measures already
taken. So bond and currency markets may exert some discipline before
structural deficits become unmanageable. Yet persuading the state to
retreat from its new, enlarged role will be no easy task.

John Plender is an FT columnist and chairman of Quintain plc