DID YOU JUST HEAR THE BOND BUBBLE BURST?

The defaultistas and hyperinflationists are enthralled by the fact that bond yields are rising.  After all, you can’t really have either of the preceding environments without rising yields.  Surely, this is a case of the bond vigilantes awaking from their slumber, right?  Not so fast.  There is an obvious flaw in the aforementioned theories that most doom and gloomers refuse to admit – the economy is getting better and yields are reflecting this environment.

First of all, let’s put things in the proper perspective.  Below is a chart of the 10 year treasury yield.  The recent move in yields that is causing so much fuss is magnified in the box below.  I only magnified it because the move is literally so tiny within a historical context that the reader cannot actually see the uptick without 3X magnification:

But why are yields rising?  They are rising because there has been a whiff of economic recovery in the air (this is dramatically different than the reasons yields are rising in periphery Europe for example).  Many investors like to conclude that QE has been highly successful in recent months because equities have rallied.  But if you recall correctly, the equity market rally started when double dip fears were high and the August global PMI’s and USA ISM surprised sharply to the upside.  That rally was followed up with jobless claims falling almost 10% in the ensuing 2 months and an earnings season that showed broad and impressive strength.  In late August I explained what would lead to rising yields:

“Inflation will likely occur during a recovery.  And by then all of this chatter of default and USD collapse will be long gone.  It might get the hyperinflationists hyperventilating again, but these same people fail to understand what hyperinflation actually is – it is the death of the currency that generally occurs due to a lack of faith in that currency.  And that my friends will not occur if we experience a booming recovery and a surge in loan growth.  The two simply do not go hand in hand.”

A few days prior to this I said that long bonds were not a great bargain, but also not a bubble:

“While a 10 year U.S. treasury at 2.6% might not be the world’s greatest bargain it’s entirely incorrect to argue that there is a “bubble” in government bonds. In fact, I would argue that the term is not even applicable.”

What is most interesting here, however, is that the Fed has displayed a remarkable inability to control the long end of the curve.   I think Mr. Bernanke would need to dramatically alter his QE approach if it is going to have a meaningful impact on long-term interest rates.   In essence, he would need to place a bazooka on the table by setting a target and by being a willing buyer at that price.  Otherwise, yields on the long end will remain controlled by market forces and not Fed forces as they so powerfully impose at the short-end.

All in all, the markets are starting to sniff higher rates of inflation via the recovery process.  For bondholders who are using this asset class as it was designed (to be held to maturity and as a hedge in a diversified portfolio) the recent (minor) move in yields is no reason to panic.  For the hyperinflationists and defaultistas out there who are calling for doom and gloom and Zimbabwe 2.0 – I can only say – don’t hold your breath.