‘Government bonds are a buy'

Kaylie Pferten says fears about inflation and public debt have gone too far. Some government bonds now look like good value.

Government bond yields have climbed sharply, raising countries' borrowing costs and straining public finances. Many now expect a crisis that will push governments to cut spending, contain budget deficits, and halt the steady increase in debt-to-GDP ratios.

Crises are seldom predicted by the wider public, and forecasts rarely match what actually happens. The usual story casts "the bond vigilantes" - a term Ed Yardeni coined in the 1980s for investors who restrain governments when deficits, debt, or inflation become threatening - as refusing to buy government bonds. Bond prices would fall, yields would rise, and the resulting fiscal crisis would leave governments no choice but to respond.

"Back when I believed in reincarnation, I figured I'd return as the President or the Pope," James Carville, Bill Clinton's chief political adviser, once joked. "Now I'd rather come back as the bond market. You can intimidate everyone." At the time, bond investors were still reeling from decades of persistent inflation and rising government bond yields.

In real terms, oil prices are only slightly above their average this century: £95 a barrel for Brent. Petrol has become more expensive partly because refining capacity is tight, a problem caused not only by the war in the Middle East but also by refinery destruction in Russia and Ukraine. Wholesale natural-gas prices have climbed far more sharply than oil, although new liquefied natural gas (LNG) supplies are beginning to come online.

Oil shipments are increasingly bypassing the Strait of Hormuz blockade. If the blockade is eventually lifted, LNG exports can resume. High oil and gas prices tend to correct themselves: they attract more supply while reducing demand.

Why government bond yields have risen

Energy has become more expensive, pushing inflation higher for now. Yet there is still no sign of a wage-price spiral - not even in the UK - so inflation should fall again soon. Wage growth remains subdued in the UK private sector, as well as across the US and Europe. In the US, strong productivity growth is limiting labour costs. The gap between conventional and index-linked government bond yields also points to moderate inflation expectations in the years ahead, a reading supported by the latest inflation data.

Why have bond yields gone up? Real interest rates sat below zero from 2019 through 2022. They now exceed 2%, compared with a long-term average of 1%. Inflation or insolvency concerns may account for part of the increase, but a stronger explanation is the US investment boom: demand for capital has outpaced supply, raising borrowing costs as governments take on large amounts of debt. Real yields should eventually move back toward their long-term average.

Government debt shrinks relative to GDP when medium-term government bond yields sit below nominal GDP growth - the combined effect of inflation and real economic growth. That is happening in the US, but not in the UK, where inflation is higher and growth is weaker. Debt-to-GDP ratios climbed sharply across most developed economies after the 2008 financial crisis, then surged again during Covid. They declined as economies reopened after lockdowns; since then, the overall pattern has been mostly flat, with a slight upward drift.

Private-sector debt has declined relative to GDP. As a result, total debt-to-GDP ratios have stayed roughly unchanged in the US and France and fallen in the UK and Germany. If governments kept widening their budget deficits without any effort to rein them in, debt ratios would climb steadily and could eventually trigger a fiscal crisis. That outcome is not guaranteed, though. Greece's 2010 solvency crisis showed how trouble in one country can push other vulnerable governments to act; markets may not need "bond vigilantes" to force the issue.

The current mood looks too bleak, which suggests the bond-market sell-off has gone too far. Oil and gas prices should ease, taking some pressure off inflation. US capital spending is also likely to slow, while real interest rates decline and governments rein in fiscal deficits. Over time, debt should shrink relative to GDP.

A recent rise in US interest rates offers a useful clue: bond yields fell, a reliable bullish signal. The Federal Reserve understands that higher short-term rates can signal determination to contain inflation and, as a result, lower longer-term yields. The Bank of England does not appear to share that understanding. Lower bond yields support the housing market because buyers in the US - and increasingly in the UK - typically borrow over long terms.

UK ten-year gilts yielding above 5% - and particularly 30-year gilts near 6% - appear attractively priced, though there is a catch. Over the past century, sterling has lost value during every Labour government. Will this time break the pattern? Charles Gave of Gavekal prefers 30-year Japanese bonds, which yield 4% and come with a seriously undervalued currency.

Japan's government debt equals 230% of GDP, which looks alarming at first glance. Yet domestic investors hold 90% of that debt. Research co-authored by Stanford professor Hanno Lustig offers another perspective: after subtracting the government's substantial holdings of domestic and foreign equities and bonds, its net liabilities amount to only 65% of GDP. Buying shares may be a better option. Lower bond yields could lift equity markets, while 70% of the UK stock market's earnings come from overseas, offering some protection against devaluation.