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The Next Crisis: Imploding Bond Markets

Sam Vaknin, Ph.D. - 11/16/2008

To finance enormous bailout packages for the financial sector (and potentially the auto and mining industries) as well as fiscal stimulus plans, governments will have to issue trillions of US dollars in new bonds. Consequently, the prices of bonds are bound to come under pressure from the supply side.

But the demand side is likely to drive the next global financial crisis: the crash of the bond markets.

As the Fed takes US dollar interest rates below 1% (and with similar moves by the ECB, the Bank of England, and other central banks), buyers are likely to lose interest in government bonds and move to other high-quality, safe haven assets. Risk-aversion, mitigated by the evident thawing of the credit markets will cause investors to switch their portfolios from cash and cash-equivalents to more hazardous assets.

Moreover, as countries that hold trillions in government bonds (mainly US treasuries) begin to feel the pinch of the global crisis, they will be forced to liquidate their bondholdings in order to finance their needs.

In other words, bond prices are poised to crash precipitously. In the last 50 years, bond prices have collapsed by more than 35% at least on three occasions. This time around, though, such a turn of events will be nothing short of cataclysmic: more than ever, governments are relying on functional primary and secondary bond markets for their financing needs. There is no other way to raise the massive amounts of capital needed to salvage the global economy.