The prices for bonds move inversely to the interest that they pay to investors. When bonds are in high demand, prices increase and bond yields decrease. Probably the biggest financial story for 2014 thus far is the unexpected demand for bonds. If you were wondering just how strong the recent rally in the bond market is, a new report from Deutsche Bank states (via The Economist) that Dutch sovereign bonds are now paying near to their lowest yield since 1517 — that’s right, 1517, 497 years ago.
Market commentators are scratching their heads and wondering how bonds can be in such demand while stock prices are also relatively high. Typically, the bond market does well when the stock market falters, and vice versa. There are lots of possible explanations. Here are the ones I’ve heard:
- After the banner year for stocks in 2013, investors the world over are re-balancing their portfolios to trim equity gains and re-allocate to fixed income.
- Pensions funds are locking in their stock gains since the financial crisis by buying bonds, in order to meet their long-term payout obligations.
- Aging populations in developed economies are driving a structural shift in aggregate investor preferences towards the security of bonds.
- Institutional investors made macroeconomic bets at the outset of 2014, predicting interest rate increases, and shorted bonds. They’re now having to cover those trades since interest rates haven’t risen, but decreased, and bond prices are inflated by the resulting short squeeze.
- The Federal Reserve, the Bank of Japan, Bank of England, and other central banks are inflating bond prices by buying huge quantities of bonds.
All of these factors are probably contributing to the bond market rally, but I’d guess that central bank policy and demographics are the most significant. An indication of how powerfully central bank policy has influenced the bond markets is the relative expense of US versus Spanish government bonds, which I’ve remarked upon previously. Here’s a chart courtesy of UBS:
Although the Spanish economy appears to be recovering, it has debilitating structural weaknesses compared to the U.S., including a declining population and crushing levels of unemployment (especially among those under 50), and there’s no reason, apart from central bank distortions, why Spanish bonds should be priced as less risky than the U.S.