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Government bonds: The great bond conundrum

Huge supply, uncertainty over the inflation outlook and the effects of exceptional monetary policy, the prospect of a dramatic rise in yields, or a buyers’ strike: all these are stalking government bonds. Alex Chambers finds out whether the bond market will blow stuttering economic activity off track.

A KEY TENET of economic theory is that if the supply of a good doubles, then the price buyers are willing to pay is likely to decline dramatically – all things being equal. In the case of government bond markets, huge additional supply will lead invariably to higher yields – at least hypothetically. And yet two years into the crisis, and back in the real world, yields are lower because not all things remained equal. Investors’ risk aversion, interest rate cuts and various unorthodox central bank actions have helped suppress interest rates.

Nevertheless, plenty of experts predict doom and gloom for the fixed income markets and therefore the wider economy. The level of government intervention has been extraordinary, with hundreds of billions spent or committed in various forms of financial support and debt guarantees. It’s hardly surprising that concern over the extent to which states can sustain these efforts is building. The general concern obviously is directed at the short- and long-term impact of huge budget deficits, greater debt to GDP ratios and inflation.

Most agree that governments’ and central banks’ actions were justified because they softened the blow of what would otherwise have been a very painful deleveraging of banks’ and consumers’ balance sheets.

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