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Government Bonds: A Game of Chicken?

Updated: May 20, 2022

Over Chinese New Year I went trekking in Nepal. On the long drive to the starting point we were held up at a roadblock by villagers who told us we would not be able to pass for two hours because a chicken had been run over. Settlement negotiations were taking place between the owner of the chicken and the owner of the offending vehicle, mediated by the police, and out of respect the road had been closed. Apparently the owner of the chicken could expect to receive in compensation up to three times the chicken’s “street value”. While it amused me greatly to imagine the police officer asking the owner why his chicken had crossed the road, the episode got me thinking. Why was the chicken worth so much more as road kill? What is the economic cost of holding up traffic in such instances?

"I was about to offer to pay ten times the chicken’s value to expedite our release"

With regard to the first question, my guide was not able to provide an answer, at least not a very helpful one. When asked, he simply shrugged and said “local people” as if their demand for three times the chicken’s value was irrational and thus unfathomable. I was not so sure, and concluded that there may have been an element of means-testing at work. The owner of the vehicle was obviously wealthier than a normal vehicle-less chicken buyer and so could afford to pay more. And who’s to say this was not just? Anyway, fed up with sitting around, I was about to offer to pay ten times the chicken’s value to expedite our release when we were waved through on the basis that I was a tourist and should not be detained, which kind of addressed the second question.

Value of course is an intangible thing. It is intangible because it is subjective, as the chicken episode so aptly demonstrated. Buyers’ and sellers’ valuations of a particular thing define supply and demand curves which in turn determine price.

Furthermore, a natural asymmetry results from sellers knowing more about what they are selling than buyers. You’re probably now starting to wonder where this is all going. Well, what I’m pondering is whether there now exists the “mother of all asymmetries” in one of the world’s most important and liquid financial markets: government bonds.

Think about it. Where is the value in government bonds? The collateral that backs government bonds is not some physical asset but simply the ability of governments via their central banks to print money. But printing money of the sort we are witnessing currently across the developed world can lead to unexpected inflation which is bad for bond prices. So bonds in major economies such as the US, UK and Japan are being bought on the basis of a perceived strength (governments’ ability to print money and thus not default) which in reality is a weakness (money printing can lead to inflation which can be bad for bonds).

This may all sound a little simplistic; given the situation described above, why would anybody continue to hold government bonds? Well, although the longer term outlook for bonds may be negative, in the medium term bond yields could fall further.

Unemployment in the US remains high at around 8%, and is over 25% in countries such as Spain and Greece (with over 50% unemployment among these two countries’ under-25s). Considering this spare productive capacity, money supply alone is unlikely to be an inflationary driver in the West. Deflation remains a real threat.

Perhaps for an absolute return investor there is little value in government bonds, but there is security if equity markets wobble and the world begins worrying again about European or US growth. The danger is that one imagines there is little to stop someone waking up one day and realising that they should care about the real value of the dollars, pounds, or yen they will receive at maturity, not the nominal value. If that happens en-masse, as things tend to in financial markets, the result could be dramatic.

Published in Aberdeen marketing

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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