Thursday, 2 August 2012

Graph of the week: 150 years of bond yields

This week's graph offers several interesting facts to ponder upon: (click to enlarge)

Source: The Economist, July 2012
It seems that high spikes in bond yields were a natural occurrence in the 70s and the 80s during times of high inflation. Even in the 90s, average US and German bond yields were still higher than what Spain and Italy have today. And it was interestingly in the beginning of the 90s that Spain and Italy started to diverge against US and German yields just as they are doing today. The convergence came soon enough, or to be more precise, a bit before adopting the euro and agreeing to the necessary convergence conditions

However, the divergence of today is really simple to explain. It’s all a question of risk perception of investors where bonds of countries like USA, Germany or the UK (not pictured), no matter how bad their fiscal position is and no matter what the rating agencies say, are still regarded as ultra safe investments. On the other hand, this is due to the relatively high risk exposure of all other Eurozone countries. It appears that investors think that the US or the UK still aren't as bad as Greece or Spain, so they buy into their bonds. The real panic and downturn on the markets will begin when the previous statement will cease to be true.  

Another interesting fact is the question of when exactly did the idea of bond yields being considered the safest assets commence? It probably came about quite recently, following a steady 30-year decrease of US and German bond yields (a consequence of the “Great Moderation”), with all other yields converging to similar low rates. 

If you look at this in retrospect, something artificial had to have happened to keep all these yields exactly the same for 10 years (end of 90s to the end of the 2000s). Looking at the series historically, there was never a time when these yields were moving so closely together, not even in the beginning of the century in the prelude of the Great Depression. The artificial aligning of the yields had nothing to do with the Great Moderation. The culprit was the idea that all countries should bear no risks of borrowing within a highly controlled monetary union accompanied with a regulatory paradox that made all this possible. The aim was to eliminate risk for all countries within the Eurozone, a venture that has failed hopelessly. History teaches us that some difference between countries in their relative exposure to risk has to exist. An attempt to prove otherwise results in disaster. 

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