World War II: What the Bond Markets Reveal

I wrote last month about how movements in the Iraqi bond market may tell us more about the effectiveness of the surge in U.S. troops than other more commonly cited statistics in the media.

The reason for this: An event as cataclysmic as war puts extreme pressure on a country's finances and increases the chance that it will default on its debt. Investors are likely keeping a very close eye on developments and sending bond prices higher when conditions improve and lower when they deteriorate.

(In the case of the Iraq surge, this dynamic suggested that things weren't going well.)

Can a similar approach give us insights that have been overlooked by historians?

To investigate, Bruno S. Frey, an economist at the Institute for Empirical Research in Economics, and Daniel Waldenstrom, an economist at the Research Institute of Industrial Economics in Sweden, looked at how the government bond markets of Germany, France, Denmark and Norway fared after the rise of Nazi Germany in 1933.

Many of the nations involved in World War II either interfered with or even closed down their stock and bond exchanges, but, ever a neutral nation, Switzerland kept its markets open.

Frey and Waldenstrom used data from the Land of the Alps to identify what they call "structural breaks" -- when the moving average of a particular bond moves sharply. These breaks indicate that investors' beliefs about the future had markedly changed.

The graphics below from Frey and Waldenstrom's paper show the price jumps across the four countries, followed by the researchers remarks on the similarities and differences between historians and the market's views of the events. (The prices for France and Germany run from 1933 to 1948 while Denmark and Norway's prices are from 1938 to 1940. There's also a slight error in the Germany graphic: the battle of Stalingrad didn't happen in 1939, but 1942.)

Some of the events that are generally thought to be crucial are clearly reflected in the German and French government bond prices. This holds, in particular, for the official outbreak of the war from July to September 1939. It markedly reduced the government bond values of Germany (by 39 percent) and France (by 25 percent). The same holds for losses and gains of national sovereignty. When Belgium and France were defeated and occupied by German forces in the Blitzkrieg of May 1940, the German government bond values rose by 8 percent and those of France fell by no less than 31 percent. The same holds in the case of the two Nordic countries analyzed, Denmark and Norway. The German invasion in April 1940 was clearly noticeable on the bond market, with sharp increases in the perceived risk of a sovereign default, according to falls in the countries' bonds.

At the same time, we also note that certain events to which historians attach great importance are not reflected in bond prices at all: the most prominent example is the capitulation of the Wehrmacht in May 1945, which is neither reflected in the German nor French government bond prices. The Allied invasion in Normandy in June 1944 raised the French bond values (by 16 percent) but did not lead to a break in the values for Germany. In the case of Denmark, the non-aggression pact between Germany and Denmark at the end of May 1939 did not influence the bond market's perception concerning war risks on Denmark at all.

Finally, the results indicate situations where the claims of historians may even be questioned by the financial market evidence. For example, Nordic historians have regularly argued that the contemporaries in the Nordic countries did not perceive any increased risk of war to their own countries in the period before the war, i.e., in 1939 and early 1940.9 By contrast, the estimated structural breaks for both Denmark and Norway clearly indicate that the sovereign risk of these countries increased significantly in connection with war-related geopolitical events, and could be clearly interpreted as increasing the military threat against these countries.

So on balance, while it looks like the markets and the historians largely agree, historians could benefit from using market reactions as a complement to their analyses.