Government bond yields

Government bond yields in the first world are at or near historic lows. Corporate bonds' yields on the other hand have spiked, thereby creating a massive yield gap. Equity markets are in negative territory, both on poor sentiment and depressed earnings expectations. The value of property seems to have fallen off a cliff. We are all familiar with the past and the circumstances that caused it. The problem at hand is not the current situation, but the solution and the effects thereof.

To counteract the severe credit and economic crises governments use various combinations of fiscal and monetary policies. The first reaction in many countries was the reduction of their central bank's lending rate. In some instances this coincided with other monetary actions such as buying various securities in the open market or over the counter. Essentially governments attempted to flush the system with money to kick-start economic growth.

In addition to this, governments use fiscal policy to increase spending by using instruments ranging from a decrease in taxes to an increase in infrastructure spending, but to do this they need money. A state essentially has 3 sources of capital:

They can raise it via taxes They can borrow it in the capital market The central bank can print it For all intents and purposes only the first two are used in modern economies. When the state starts printing money to fund itself, situations like Zimbabwe result. In the current crises the only viable source is borrowing money - as reducing taxes is part of the fiscal stimulus plan.

Debt works the same way for governments as it does for you. The government is borrowing against future income from taxes. Another issue is that during economic downturns tax bases are much smaller than usual. This means government needs to spend more on infrastructure, while taxing a smaller base less than it did in the past. All of this leads to a burgeoning public debt. The average increase in the real value of public debt after a financial crisis is 86%(1). This money has to be repaid sometime in the future.

Governments however possess a single weapon you and I do not - inflation. Because debt is mostly issued in nominal terms, a high inflation rate will go a long way in reducing this debt in real terms. Governments often inflate their way out of public debt problems.

Thus we have a monetary policy that flushes the system with money (which causes inflation in the long term) and a government with a vested interest in higher inflation rates. This would seem to indicate that while global and local inflation seems to be under control at the moment, there is a real possibility it could spike in the future.

When inflation starts rising you want to be in real assets rather than any form of fixed interest instruments. Bond yields rise with inflation, causing capital losses.

While holding onto cash in the short term seems to be fashionable, this has problems of its own. Interest rates are falling, which means the returns on cash are decreasing. Furthermore, sometime in the future inflation is going to be a problem and you will need to hold real assets. Buying into equities now may seem risky, just keep in mind that there are currently good buying opportunities and you will need to hold equities to protect you from inflation in the future. High inflation will come, the only question is when.

Reinhart, Carmen M & Rogoff, Kenneth S (2009), The Aftermath of Financial Crises, American Economic Association presentation

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