Why the politicians are wrong and the deficit doesn’t matter: Kohler

The Japanese 10-year bond yield has fallen below 1% for the first time in seven years, as bond yields everywhere continue to tumble.

The US 10-year rate has fallen below 3%, from a peak of 4.01 in early April; the yield on German bunds is down to 2.6%. In Australia the 10-year bond yield has recently dipped below 5.1%, an 18 month low.

There is plenty of debate whether all this is good or bad – that is whether it heralds deflation or not – but one thing is certain: the warnings that “bond vigilantes” would punish profligate governments have not come to pass. The promoters of budget austerity on the basis of what financial markets will do to interest rates are losing the argument.

It’s unlikely that the behaviour of global bond investors will enter the Australian election campaign, but investors’ insouciance in the face of large and rising government deficits completely undercuts the argument that there is a problem with debt and deficits in Australia.

In fact right or wrong, bond markets are screaming deflation, not inflation, and both retail and institutional markets are pouring money into bonds, and out of equities, so there is no problem soaking up the colossal supply of government debt.

Whether the Australian budget moves into surplus in 2013, 2015 or 2020 will make no difference to interest rates, either short-term or long-term.

The provincial obsession with Australia’s paltry level of government debt is absurd – and a distraction from the desperate need to invest in infrastructure.

Even the project declared to be the most important in living memory – the national broadband network – is being funded as a sort of PPP with the private sector to keep it off the government’s books, even though the demand for government debt securities means it would be more cheaply funded entirely by government.

And don’t get me started on the state of our public transport, roads, freight systems and hospitals, although the education system, at least, is now well supplied with gymnasiums.

As for what’s going on with Japanese bonds – it appears China is adding to the elevated private demand for yen denominated bonds, buying 1.27 trillion yen worth up to May according to the Japanese government.

The yen has climbed 10% against the US dollar in the past two months, prompting the Japanese Finance Minister to try to talk it down, although few believe the government would actually intervene. Such action would be doomed to failure, especially if it was up against Chinese buying.

In fact the yen, and yen bonds, have become an alternative safe investment to gold. They are the only two assets now higher than they were immediately after the collapse of Lehman Brothers in 2008 (gold is up 30%, the yen/USD rate is up 22%). In the past six weeks, though, the yen has gone up 5% and gold has fallen 5%.

US bond yields are falling because both banks and households are soaking them up as fast as they can be printed. The savings rate in the US has risen to 6.4% and most of that money is flowing into bond mutual funds. And under Basel risk-weighting rules these days, banks prefer to buy government bonds than lend to businesses.

The result, as Washington blogger Stan Collender points out, is that bond vigilantes have become “deficit cheerleaders”.

But as Collender says the most interesting thing is why the bond market is not being heard or listened to by policy makers.

Basically governments and central bankers are being given permission to do more to stimulate their economies and get unemployment down but no one’s listening. The European Central Bank remains openly focused on austerity, as does the UK government. Hungary is killing itself with high interest rates and tight budgets.

And in Australia campaigning politicians remain locked in rhetorical embrace of fiscal responsibility, while dribbling out expensive promises day after day. Come to think of it, perhaps they’re the only ones taking notice of the bond markets.

This article first appeared on Business Spectator.