by James H. Nolt
Recently I ended on a down note bemoaning the prospects of generalized worldwide deflation in the near future, with potentially catastrophic effects. This week, let’s step back from this gloomy prognostication to consider the dual nature of bonds.
Bonds are assets that are traded at a current market price, like any asset, commodity, good or service. But bonds are also circulating credit, having a fixed face value payable at maturity. Thus bonds create a link between current conditions and a promise of future redemption. They are the most wizardly of the financial assets.
The total value of all extant bonds worldwide (somewhat more than $100 trillion) greatly exceeds the total market value of all stocks on all the world’s stock markets. Bond markets are both more wizardly and bigger than stock markets, yet most ordinary people hear much more about stocks and stock prices than they do about bonds, so the common impression is that the stock market reflects the state of the economy, whereas the bond market is largely invisible outside the circles of professional traders and investors.
In fact, the strategic nature of the business cycle is much clearer when one examines market conditions for circulating credit instruments, of which bonds are the greatest and longest-enduring component.
Last week I suggested that the world faces the possibility of general deflation, leading to a worldwide economic crisis, such as happened during the deflation at the time of the Great Depression. This week I explore an important clarification of the notion of general deflation. Since all prices are ultimately relative prices, strictly speaking, a general deflation is impossible. However, if the prices of real goods and services, measured by the Consumer Price Index (CPI), are going down; real estate prices are falling; and stock prices are crashing, that is as close as we ever come to general deflation.
In that case, however, the value of something else is rising. As I said before, inflation can be thought of as the prices of most things rising or the value of money falling. Conversely, deflation can be considered either the decline of most prices or the rising value of money. Never forget (as economists often do) that the rising value of money means also the rising face value of bonds, denominated in that currency. Bonds and other debts fixed in money terms, increase in relative value during deflation. This is what makes deflation so pernicious for debtors.
If you hold lots of money, bonds and other assets whose ultimate value is fixed in money terms, then deflation and even depression may in fact increase your relative wealth. This gets back to the point I made at the beginning of this blog series: no state of the economy is good for everyone and no change in the economy is bad for everyone.
Now here is the point where bonds are most tricky. Their ultimate promise to pay is fixed in money terms (though remember, money itself varies in value), but their current market prices vary according to the perceived risk of default and the current supply and demand for credit, affecting the interest rate and therefore the current market price of bonds. During a general deflationary crisis, it is quite possible for the face value of bonds to increase (coincident with the increasing value of money) while at the same time the current market value of bonds decreases. Their current price will fall if either interest rates or the risk of default increases. Both of these do tend to increase during a deflationary depression, such as the Great Depression or the series of sharp depressions during the last third of the nineteenth century. Part of the wizardry of bonds is that they are one of the few things that can both rise and fall in value at the same time.
German philosopher Friedrich Nietzsche famously said, “Whatever does not kill me makes me stronger” (though this was most likely uttered cynically). This is true of bonds during a deflationary crisis. Some bonds will default when their issuers go bankrupt or, in the case of sovereign debtors, they may simply refuse to pay. Other bonds will fall precipitously from the fear of default, only to recover in value as they near redemption at their maturity date. Still other bonds fall in value because rising interest rates divert capital from bonds to loans.
But regardless of what happens to the market price of a bond during its lifetime, if it “lives” to the moment of its maturity, and the issuer is solvent, it will pay its face value. If that value has been diminished by inflation, the bondholder loses relative to owners of other assets whose prices have inflated, but if the value of money increases, the bond is also worth more at maturity. Bondholders hate inflation and love deflation. The owners of most other assets and most debtors have the opposite interest.
Thus a general deflationary crisis is a great opportunity to buy assets at a discount. The bears have a field day. On the other hand, bonds can be a good buy in both inflationary and deflationary crises. During inflationary crises, bond values typically fall rapidly because the falling value of money also means the falling value of bonds denominated by money. The last severe inflationary crisis in the U.S. and worldwide occurred during the early 1980s when bond prices because seriously depressed by double-digit inflation. The other side of that coin is that long-term interest rates reached record levels.
Ever since the early 1980s, there has been a strong trend for inflation to decline along with interest rates. This has created a strong bull market for bonds, since their prices steadily rise. By the early 21st century, bond prices had reached heights never before seen in world history. In other words, interest rates were as low as they have ever been. Anyone who bought long-term bonds at the peak of the inflationary crisis in the early 1980s made a fortune.
Today bond prices are so high they probably cannot go much higher. One could say there is a bubble in the worldwide bond markets. In a few places, like Greece and a few other European countries, that bubble did burst temporarily, only to recover. If bond prices worldwide begin to fall, thus causing interest rates to rise, the world could sink in a quagmire of increasingly expensive debt. More on that next week.
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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Simon Cunningham]