Bubble in bonds may be about to burst

Just over three years ago, a run on the Irish economy began. Among other things, the price of Irish government bonds fell as investors dumped them. Within months, the State was in a bailout and still is.

But from the middle of 2011, when Irish bond prices fell to unprecedented lows on the growing expectation of default, a remarkable turnaround occurred. The fall in yields on bonds (their effective interest rate, which move inversely to price) continued, interrupted only by outbreaks of panic about the euro’s future.

By May last, yields had fallen below pre-crisis levels. But how could investors believe the default risk on Irish Government bonds was lower in May 2013 than five years earlier when the stock of outstanding debt was a fraction of what it is now?

Widespread bubble
The explanation is – in all likelihood – a geographically widespread bubble in the government bond market.

In recent times some governments have been able to issue bonds paying out unprecedented low rates of interest. Even the euro zone periphery joined the party in the global bond market after the unveiling last summer of the European Central Bank’s bond-buying programme.

By the beginning of May, yields on German, British and US government bonds, considered among the safest securities of that maturity anywhere, hit historic or close to historic lows. Euro zone peripherals were tapping the market at rates that made their huge debts more manageable.

But the bond bubble may be bursting. Since early May yields have been rising.

Yesterday, the US 10-year [bond] rose above the 2.4 per cent threshold for the first time in two years. The equivalent German bond has gone from 1.2 per cent in early May to close to 1.7 per cent, a six-month high.

The Irish Government bond market has been correcting too. Yesterday, the yield on the two-year hit its highest level since January when it closed shy of 2 per cent. A month ago it was 0.8 per cent.

The uptick in the five-year has been slightly less dramatic. In May, the yield had sunk to 2.1 per cent. Yesterday it hit a six-month high, rising above 3.2 per cent.

The bubble has inflated in the bond market and if this is the start of a correction, it will not be pretty. Exit from the bailout at the end of the year could be among the victims.