BOND BUBBLE?
Many are talking about the bond market being the latest bubble. But it looks more like the press is just seeing bubbles everywhere. To me a bubble happens when everyone starts believing something that probably is not true. For example in the 1990’s investors started thinking that the long term earnings growth of the S&P 500 was shifting up from its long term 7% growth rate. So they believed that the market was worth more than historic valuations implied and the market PE rose to the 25 to 30 level.
In the 2000’s bankers and home owners came to believe that housing prices could never fall so that homeowners could always refinance their mortgages. Consequently, lenders did not have to worry about credit risk.
So for the bond market to be a “bubble” investors would have to start thinking they can make unusually large capital gains in the bond market. But everyone knows that if you buy a 10 year bond that at the end of 10 years all you will get back is your original investment. In the meantime you will get the coupon and what you can earn by reinvesting that coupon. Yes, if rates continue to fall in the short run you will be able to sell the bond for more than you paid, but you total return has to remain limited because in 10 years the possibility of capital gains must converge on zero. As long as this is true the possibility of a bond bubble must remain something reporters and pundits can pontificate on but nothing more than that.
May or may not be a bubble, but a 1% rise in interest rates, and bonholders will see a significant decline in value on teh long bond, and a pretty good haircut on the short end.
http://economistsview.typepad.com/economistsview/2010/08/paul-krugman-appeasing-the-bond-gods.html
Comments are interesting.
If the bond market contradicts your ideological notion that government spending is the source of our problems, you’re more likely to view it as an irrational bubble.
If you think the bond market is telling you something important about economic weakness, you’re likely to think of it as a rational response to current conditions.
eightnine2718281828mu5– very, very good.
another definition of bubble would be overinvestment to the point where returns from an investment can no longer possibly support the price.
let’s consider the 2 year US treasury for a moment. it currently yeilds 48bp. (0.48%)
after tax, you won’t do better than 40bp.
to buy this bond in expecting any sort of real return, you have to beleive that inflation will be below 40bp over the next 2 years. given the views on deflation often espoused by “helicopter ben” our current fed president, is that really a rational expectation? even the highly slanted CPI is running 100 bp agead of this, and PPI is showing 4.4% yoy increases.
so how is driving the price of an asset to the point where it almost certainly has negative real returns not a sign of a bubble?
the rally in bonds is especially poingant in light of the huge multi year rally in gold that has gone with it. the bonds are betting on deflation. gold is betting on inflation/currency debasement. both cannot be right and both have had historic rallies. somehting is in a bubble. (quite possibly both)
tyger has caught the one situation in which the math of continued appreciation in Treasuries works out. If we have persistent deflation for several years (doesn’t need to be all the way to the maturity date of the Treasury security), then “real” Treasury prices can rise given any positive nominal yield.
Alternatively, you could just see a large holding of Treasuries as a necessary part of a portfolio that faces a substantial risk of capital loss from other ocmponents of the portfolio.
Both views at work at the same time could explain a lot, but I’m not sure even that would justify the “bubble” label. spencer says investors in general have to have an expensive view that proves wrong for their to be a bubble. My understanding of the term has always included a speculative element, which promises to get today’s holder of the asset out at a higher price because some other investor will want it at that higher price. Prices come untethered from expected income, and rely very heavily on anticipated capital gains. Neither worry over losses on other assets nor anticipation of deflation meets the definition with which I am most familiar.
Consider that both may be held as a way to preserve value when other assets look riskier than one would like. I realize that gold has long been seen as an inflation hedge, but even longer as a hedge against loss of asset value from other causes – war, expropriation, exile and the like.
If the explanation for both is that they will maintain value, then we aren’t necessarily looking at a disagreement over consumer price trends. It could be a disagreement over the default risk on Treasuries. It could be that those adds touting gold “delivered to your door” have touched an irrational dendrite somewhere in the brains of many, many TV watchers.
When markets do unconventional things, we ought at least to consider unconventional causes.
Tulip bulbs eventually have to be planted or they decay but that upper bound on total return didn’t stop that bubble. The bubble mentality is where prices lose any connection to the underlying asset/business because the market participants focus primarily on playing each other, so the market becomes a game of musical chairs.
kh-
yes, both are ways to preseve value, but they do best at doing so in opposite situations. gold does so under inflation and times of currency debasement. that is rpecisely the situation in which bonds get killed. bond do best in times of recession and deflation, periods in which gold should do badly.
monetarily, bonds should do well is money supply contraces, and gold if it expands.
so yes, both are ways to preseve value, but not at the same time. at least one is likely in a bubble.
investors do currently have an expensive view on bonds. if inflation or rates pick up, it wopuld result in large losses. if they just stay flat, they will still suffer losses. asset managers tend to view bonds as just another asset. they trade them and take capital gains. at this point, the sort term markets are priced such that there gains are literally all but impossible.
some of this “bubble” has been driven by forced buying out of banks due to tighter tier one requirements and the ability to leverage a steep spread. (though this involves considerable timing risk) if they get caught out borrowing heavily short to buy long, you’ll see what a bond bubble bursting looks like. people talk about bonds in terms of yeilds, but they trade at a price that creates they yield given that they are worth par at expiry. so, you can buy a 2 year at 0.479% yield and lose piles of money on it if rates are 5% 2 years from now, especially at 20:1+ leverage. such a crunch could wipe out 80% of your capital. that would make an equity crash look benign.
i would argue that replacing higher yielding risk bonds with low yeilding govvies at higher leverage is a bubble of sorts. spencer’s notion that it has to be proven wrong to be a bubble is a bit problematic. that pretty much means you can never call a bubble until it bursts, right? how else would you know it is wrong?
that leads me to prefer a definition grounded more in return based on price.
I’m inclined to disbelieve in the bubble but for long-term debt there is a long period for their values to fluctuate and as somebody said, the market can stay irrational longer than you can stay solvent, or something like that.
“…both are ways to preseve value, but they do best at doing so in opposite situations. gold does so under inflation and times of currency debasement. that is rpecisely the situation in which bonds get killed. bond do best in times of recession and deflation, periods in which gold should do badly.”
The use of superlatives is where your analysis comes apart. The point I made is that, in situations other than a loss of price stability, both Treasuries and gold could serve similar purposes in a portfolio. Your response is to declare that each does “best” in one or the other form of price instability, but without evidence. All you have done is claim that the commonly cited situation is the “best” situation, without a shred of evidence.
We now have three definitions of “bubble” at work. That is, in fact, the problem with analysis by label. I offered a definition, and probably will regret having done so, only because it was not my definition, but one I was taught was “the” definition. Now I see spencer declaring that being wrong by a lot is the defiintion and you looking at return. At which point, I have to say, we don’t need no stinkin’ labels. If we don’t know what the other guy means by “bubble” then we don’t actually know what condition the other guy is trying to discuss. Far better just to identify the condition. I’d also be wiling to bet that a lot of the “Treasury bubble” claims we are seeing right now are from people who haven’t even thought through what they mean by bubble. The term draws attention, and has emotional impact, and that is all they need.
I think on the long end, 10s and 30s, we have a new kind of bond risk. I’ll call it trading risk for lack of an official word. My theory is if holders are rational, and are ignoring inflation risk over the next 10 or 30 years, that implies no one intends to hold long term bonds for that period and are buying them just because the coupon is bigger than a t bill or 2-5 year. Or the really fancy traders are playing changes in the yield curve shape.
So the way I think trading risk works, since we have so many big banks in the market, is like this.
All bank CEOs have special cellphones. They come with a Big Red Button that says “Eject all treasury holdings”. This way they can make emergency decisions during trading hours while at the Hamptons, at a bridge game, or any other embarrassing place they may be. A similar sat phone is mounted in a glass case on the yacht located right next to the glass case with the axe, and the glass case with the FIRE extinguisher.
These devices are directly connected via a 4g adapter to the corporate supercomputer. This computer runs keyword detection software looking for words like “CPI” “PPI” consumer prices, wholesale prices, etc and is connected by very, very big pipes to the API press release outlet and any applicable government reporting sources.
The bond trading software can be overridden by the Big Red Button. Upon receiving the special command from the chief, the trading software dumps all long dated treasuries and any CDS held by the firm no matter what the CDS was written against. Simultaneously a client note is created advising clients to buy long dated treasuries and is sent to the high speed e-mail server.
This system is tested 3 times a day by a team of highly paid network engineers.
Disclosure: I don’t own any.
I’m ready to get out of stocks and bonds entirely, and buy equity-indexed annuities.
If the S&P rises, I get the gain (up to a cap, typically, 16%).
If the S&P falls, I lose nothing.
If in fact, if it falls, I have a better chance of a gain the next year, for I have a lower base for any appreciation.
With a minimum interest rate of 2-3%, why would anyobe buy a taxable Treasury?
Don Levit
kh-
it seems to me that it is you who are making claims without evidence. i do not think you are following what i am saying, so let me try again:
do you dispute that bonds currently have negative real returns? do you dispute that they would lose significant value in real terms if either rates rose or inflation picked up? the point here is that for US bond returns to be strong, you need the real value of a dollar to be maintained or increase. this is not some theory, it’s an indisputable financial fact. bonds become dollars.
buy a one year bond at .99 and you get a one year nominal return of 1% when you redeem it for 1.00. if the value of a dollar has delined during that time, you may wind up with a loss in real terms (buying power). there is absolutely nothing debatable about that. nor is there anyhting debatable about the fact that with current yeilds, even current inflation levels provide negative real returns. thus you have to be making a bet on disinflation or even deflation to think they will pay in real terms.
but a delfationary environment is very bad for gold (and all hard assets) if the value of a dollar rises, it buy more commodities. there is also really nothing debatable about that.
even if inflation were 1%, you’d be better off holding hard assets right now than any US bonds with duration inder 5 years.
so the two markets appear to be making different bets about inflation and money supply. my suspicion is that this has more to do with a divergence of opinion about what is going to happen than rational pricing in of one set of expectations. but, as the future unfolds, someone is going to be wrong. this is the equivalent of one gambler betting red and the other black before the wheel is spun. both are not going to be right 2 years from now when the ball has stopped.
so what is this situation in which both gold and bonds provide simultaneous protection of value? you speak of such a thing, but do not describe it. i open to the idea of such a thing, but you’ll need to describe it, because i cannot see it in any sustainable term. in a very short term, you can rally both with a huge liquidity infusion, but once that begins to trigger inflation, they will diverge.
your agument about bubbles seems to be that they are difficult to define, so let’s ignore them, then you use a straw man argument about “a lot of the treasury bubble claims” that has nothing to do with our discussion. if you cannot define a bubble, then one could as easily ask “then how do you know it isn’t” as “how do you know it is?”. clearly, if we beleive that bubbles exist, then we need a definition.
i do not dispute that precise definition of bubbles is tricky, but even flights to safety can cause bubbles. put too many people in a lifeboat and it sinks.
btw-
if the topic of bubbles is of interest to you, may i reccomend an excellent book on the topic entitled “devil take the hindmost” by chancellor.
one other afterthought-
defining bubbles as requiring the anticipation of profit is, to my mind, too limited a view. i can think of numerous examples of bubbles that are driven by other concerns.
we got a mini bubble in home sales and prices from governement stimulus. (credits)
you cna get bubbles from regulatory changes as well. if sudenlly, banks are required to hold more bonds (as they were) then everyone buying at once can certainly create a bubble if demand is sufficient and the prurcahse decsion is driven by somehting other than price.
this is why i think it best to define bubbles in terms of prices exceeding rational expecations of returns as opposed to using some sort of expectations compnent (which is very difficult to determine in any event).
Tyger is right on the mechanics.
But, I think what is being missed here is that we are solely comparing treasuries to economic conditions here in the US. This situation needs to be looked at globally, and I also think for the past 20 years we have experienced a “new” kind of inflation.
There is a lot of money sloshing around in the global system, chasing a supply of financial assets, versus chasing a basket of consumer goods. Add some leverage to that, and what we are seeing is financial asset inflation versus raw material, or basket of goods inflation. This inflation keeps shifting around to different asset classes. It was tech stocks, then real estate, and now it is a flight to safety – treasuries, and cash. So, I do see those assets as getting/being inflated, or call it a bubble if you will (I define bubble as the mania period outlined in teh post, and do not think we are there – yet). It will also continue, until there is a trigger that cause it to stop. Keep in mind it could continue for a decade! The real estate bubble took that long to form, same with tech stocks.
The demand for treasuries is not just domestic, it is foreign, and the Fed. Investors are scared of many other asset classes. I think we are seeing some unique mechanics that many financiers and economists are missing.
mc-
i certainly agree with you that increases in global liquidity and money supply have driven concatenated bubbles in varoius asset classes. commodites have been a significant postion of this as well. (the CI – continuous commodity index – doubled in 2 1/2 years to mid 2008)
however, i have doubts that one can put the current spike in bond prices down to foreign activity as a primary cause. the fed, certainly, has had a very significant impact though QE and bought up 40%+ of some of the primary treasury auctions last year. that is likely a much bigger driver. so is the increase in teir one requirements at banks.
if banks must hold more capital and that capital must be “risk free” a significant demand for bond purchases is created that is not sensitive to price. this is precisely the sort of thing that can drive a bubble.
imagine if every houeshold in america were foced to buy a new sofa in the next 3 months or face heavy fines. obviously, the price of sofas would spike, and likely we’d get a nasty bubble as demand far outstripped supply. if the government was going around buying up sofas at the same time, it would be even worse. i realize it’s a silly example, but it’s really not that different from what happened when tier one requirements were raised. sometimes these things are a bit easier to see through analogy.
to take it a bit further, we’d rapidly hit a point where sofs were selling for prices far above their worth, but if the fines were high enough, buying would continue and prices could stay high for a long time. but, at some point, everyone would have what they needed, and prices would collapse. that is how regualtory bubbles play out.
i’m not entirely sure where we are in this cycle, as bonds are not really my specialty, and i would even go so far as to say that gold is likely to more significant current bubble given the massive price move and the fact that industrial demand is down and event the jewelry and personal savings markets (india, egypt, etc) are all selling and the big net buyers are all financial, but bonds are also looking irrationally priced from a return perspective.
frankly, i would not buy either asset at the moment.
I would define a bubble as a situation in which people are willing to pay a certain price for an asset only because of what they expect other people to pay in the future even though the intrinsic value of the asset doesn’t justify the price. By that definition, the bond market is not only in a bubble now; it has always been, and always will be, in a bubble. Because bonds are paid in money, which has no intrinsic value. (Arguably, it hasn’t “always” been in a bubble, but just since the US went off the gold standard in 1971; though I would argue that gold has always been a bubble asset too, since hoarding keeps us artificially high on the demand curve, the market value ending up always far above the “unhoarded” intrinsic value.)
Max is back? Excellent news if true.
The 2/10 spread is over 200 basis points. Every time this has occurred interest rates have subsequently risen.
“but you total return has to remain limited because in 10 years the possibility of capital gains must converge on zero.”
Only the Bears and Paulie Krugnuts worry about nominal returns. The sophisticated investors worry about real returns, because they understand they are saving today to spend tomorrow and they are concerned what they can buy with it.
It is also worth noting that the Fed owns 30% of the market. Anyone think the Fed could sell that 30% stake over the next 2 years without pushing yields higher by 50-100 bps?
People buying Treasuries (like Bill Gross) are betting that if Treasury prices start to fall the guys on the NY Fed trading desk will bail them out.
BTW, Gross is despicable. He was pandering to Washington a few days ago for more Fannie and Freddie guarantees.
Another definition of bubble might be when you try and hide how big it is, or no one can really tell how big it is. (I’m just making this up as a go along here)
Consider the Fed just completed 1.8 TRILLION in QE of treasuries and MBS. The taxpayer has become more explicitly a guaranteeor of F&F MBS lately, which makes them about the same as treasuries. So that sums up to around $15 TRILLION in more or less USG debt trading out there, plus the $4 TRILLION that doesn’t trade. And yes, we the taxpayer is supposed to pay the Fed back via the Treasury. Then someone is insuring a bunch of it with CDS and interest rate swaps. There is private sector liability there. Then the Fed is continuing at a $10B/month rate. To put that in perspective, that’s how much Iraq was costing us.
If banks ever get put back on mark-to-market rules, all this stuff with low interest rates will act like hand grenades in the bank vault if interest rates ever start to move up for any reason.
As usual, and as completely predictable, Krugman is going off on rants about how we have “austerian economists” running the Fed, all other central banks, the White House, Congress, and our poor, broke, misnamed Treasury. According to Krugman they are all scared of an invisible boogeyman named “bond vigilante”. (a straw man from the distant past, IMO as well. The real one is systematic risk, I think.)
The current bond market is not rational. It has been manufactured by the Federal Reserve to drive investors into the teeth of the criminal Wall Street. Hey, put your money in stocks, the current dividend yield is competitive with the bond dividend yield.
IMO, the Southern and Northeastern Mob Boss, plantation capitalists are still targeting American savings as an opportunity for stealing. Get your retirement savings into the stock market, which is grossly (40 %+) overvalued.
The US financial markets have been harvested. There is no longer investment opportunity, no longer open and honest price discovery and no longer, growth.
The best place to be until the wheels come off the wall street mafioso machine, is governemnt guaranteed bonds. At the least, you may get your script back.
We continue to try to value the US financial market as if the greatest bank heist in history hasn’t occurred. Wishful thinking at best. The Aristocrats are stealing from us, and we are too goddamn dumb to realize what is going on.
Bubbles and troubles.
What everybody seems to forget is that FDIC insurance is limited. If you have wealth to protect, are you going to keep it in $100 cash bills? If we’re talking millions, I don’t think so. That leaves one and only one option: US Treasury bonds, bills, and notes.
The Great and Powerful Dr. Bernanke has delayed, not prevented, the inevitable bankruptcy cascade of a credit bust. Because of this, and also the continued and accelerating USG debt issuance, guaranteed government bonds are not even close to being in a bubble.
If you have wealth to protect,
What wealth would that be ? Just listen to the Dixiecrats (now republicans because of thier racist pentions). They were only Dems because they hated TR, LBJ, and JFK.
There is none so vane as a man who will not see. The US has been under attack from withiin – by the old South. David Duke (Grand Dragon of the KKK) was a major affiliate of the republican party. . These are not good people,
I guess the Civil War was not settled. Now we have Ben Bernanke calling the shots ? When will we awaken ?
andy-
in a rally driven by regulatory change, bubbles need not have a “greater fool” aspect. irrational pricing well above intrisic worth may be a rational response to legal requirement, but that does not make the pricing any less of a bubble to a marginal buyer unconstrained by regulation.
it is also worth considering that bond funds have been outperforming. investors chase performance, so more money flows to the bond funds, many of whom are only permitted to own AAA paper. this has drivent he price of such bonds down (IBM recently issued bonds at lower yields than US treasuries, the first time this has ever happened).
when too much money has flowed into bond funds, they will start to underperform and the assets become overpriced, but if money keeps flowing, they are required by their fund documents to keep buying.
so perhaps there is a greater fool aspect here as well, just one at the individual investor level, not with the banks and managers themselves.
tyger
not sure about the bubble, but you are wrong about the price. i might buy a bond expecting a negative return if the return is less negative than other options.
tyger
i think you are working too hard.
a bubble is something that expands and then bursts.
you can’t take every difference of opinioin that turns out bad for one of the parties and call it a bubble.
Sandi
i think your syntax slipped a bit there, but I like to say that the Civil War taught the Southern aristocracy two things:
It’s cheaper to rent than to buy, and white is as good as black.
Getting back on this late. I agree. Just one note I believe the demand is combined, Fed, foreign, pensions etc.
Bernanke is a liar and a thief! He is crashing this economy into the ground and we are all sitting here watching it happen. http://futuremoneytrends.com
There are a lot of trend-following momentum players in bonds, and a fall in Treasury bond prices would certainly induce further selling. Valuations are in a bubble territory. Monetary and fiscal stimulus is urgently needed to prevent the growth of the bond bubble. More here: http://themoneydemand.blogspot.com/2010/08/krugman-and-bond-bubble.html
Great depth of discussion but I would like to learn about a possible on a more superficial level. If I own $100k of TIPS what is my risk if a bubble were to burst. I realize I am protected to some degree from inflation but is my risk the fact that last year a TIPS fund gained approx 12-13% driven by monies flowing into the fund? So this is similar to an equity fund that rises with inflow of monies. Is that my risk, the value of the fund as opposed to the value of the bond. Then can you comment similarly on for instance a Bond Fund that is primarily Corporate in nature. Similar concern or different. With the fear in Europe and our own financial looming difficulties it seems to me that I have to fear the Equity market and the Bond Market due to the Bubble. Thanks. Cash is King but the King only sits on the throne.