THE MYTH OF THE GREAT BOND “BUBBLE”

There is increasing chatter of the great “bond bubble” as U.S. Treasury bonds surge ever higher and deflation fears rise. This is just one more myth that has persisted in recent years (decades really) due to mass misconception of the way the bond market actually operates and this propensity to label everything as a “bubble”.

Before we dive into the real meat of the argument it’s important that we define what a market “bubble” is. A “bubble” occurs when market forces combine to generate a highly unstable position. This results in the system entering an extreme disequilibrium and ultimately failure. The causes of this “bubble” (or extreme disequilibrium) can be many – though primarily psychological any number of exogenous factors can contribute to the instability of the system (government policy for example). The psychological aspect of a bubble is well explained by analysts at BNP Paribas:

“When interacting agents are playing in a hierarchical network structure very specific emerging patterns arise. Let us clarify this with an example. After a concert the audience expresses its appreciation with applause. In the beginning, everybody is handclapping according to their own rhythm. The sound is like random noise. There is no imminence of collective behavior. This can be compared to financial markets operating in a steady-state where prices follow a random walk. All of a sudden something curious happens. All randomness disappears; the audience organizes itself in a synchronized regular beat, each pair of hands is clapping in unison. There is no master of ceremony at play. This collective behaviour emanates endogenously. It is a pattern arising from the underlying interactions. This can be compared to a crash. There is a steady build-up of tension in the system (like with an earthquake or a sand pile) and without any exogenous trigger a massive failure of the system occurs. There is no need for big news events for a crash to happen.

Financial markets can be classified as open, non-linear and complex systems. They also exhibit emanating patterns as a result of which the “invisible hand” can be very shaky. More then 40 years ago Benoit Mandelbrot described the fractal structure of cotton prices and the emanating properties of fat tails and volatility clustering and Hyman Minsky proposed a theory for endogenous speculative bubble formation. More recently Robert Shiller and Alan Greenspan made the irrational exuberance paradigm fashionable. These all fit in the framework of Complexity Economics, which describes the properties that emerge from interacting agents. It has become clear that herding behaviour in financial markets results in positive or negative feedback mechanisms causing price accelerations or decelerations and (anti)-bubble formation, where asset prices become detached from the underlying fundamentals.”

So, we can conclude that a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. The keys here are extreme disequilibrium and systemic collapse. In order to have a bubble both aspects must occur. I will revisit this later.

There is ever increasing chatter of a bubble in the U.S. bond market. This idea of a bubble has become pervasive due to the myth that the U.S. government bond market can and will collapse under mounting fiscal burdens and the idea that bonds are “expensive” when compared to other assets.

Over the years investors have become increasingly concerned about the risk of sovereign default in the United States. China officially “hates” us. Alan Greenspan is frightened that the bond vigilantes are merely sleeping. Jeff Gundlach is worried that the United States is already insolvent. But are these concerns justified?

This brings us to a key question. Why don’t the bond auctions fail causing a solvency crisis in the USA?  This is best understood by studying the bond auction data in the USA. Despite constant shrieking of a potential lack of buyers in government bonds over the years we continue to see incredibly high demand for US debt. The auctions are always oversubscribed. They never fail. Why is this? Why do the buyers keep coming back for more? The simple answer is because the government puts the buyers there. The auctions are designed not to fail. How is this you ask?

The Federal government has a unique relationship with its central bank and banking system in which it can harness these entities as agents of the government to supply funding. Our monetary system is designed in such a way that there will always be a buyer of government bonds.  That is, the Primary Dealers are required to bid at Treasury auctions and they’re happy to do so because they’re acting primarily as intermediaries who are able to sell the bonds to clients so long as inflation doesn’t rage out of control and reduce the demand for government bonds making it intolerable for bond holders to hold t-bonds versus cash (which would also be losing value, but not principal).  And even in the worst case scenario where the banks couldn’t sell their inventory it’s likely that the Fed would step in to soak up the lack of demand. In other words, the Fed could directly fund the US government in a worst case scenario so worrying about a lack of funding in the USA is silly.  The USA has an inflation constraint, not a solvency constraint.

So, interest rates are primarily a function of perceived future inflation.  Interest rates in the USA won’t rise until spending far outstrips productive capacity as inflation begins to rise.  At this point bond traders will front-run the Fed who will likely begin to raise rates.  This won’t be a function of a solvency collapse though.  It will be a function of economic recovery or increasing inflation concerns.  The defaultistas and inflationistas get this point entirely backwards in constantly comparing the USA to Greece or Latin American nations.

Over the years the classic hyperinflationist or defaultista argument has been that China will stop buying our debt or that Japan will stop buying our debt. But the problem with this argument is that China is not our banker. Japan is not our banker. What do we care if they buy our bonds? They desire to net save with the U.S. and we happily send them pieces of paper with old dead white men on them to satisfy this desire. In recent months Chinese net holdings of U.S. debt declined:

“China’s ownership of US government debt has dropped to the lowest level in at least a year, Treasury data showed Monday, in a sign Beijing is increasingly keen to diversify out of US bonds.

The cash-rich Chinese government reduced its US Treasury bond holdings to 843.7 billion dollars in June, the lowest level since at least the same month last year, the Treasury said in a report on international capital flows.

The June data was lower than the 867.7 billion dollars in Treasury bonds held by the Chinese in May and 900.2 billion dollars in April.”

But U.S. treasury yields continue to plunge. The demand for this paper is enormous even though the largest holder of these bonds appears to be getting scared off. The demand is well beyond what the Fed even requires (as previously explained). While the Chinese fret about U.S. insolvency we’ll gladly keep sending them pieces of paper in exchange for real goods and services. If they desire to save less (which actually benefits their citizenry) then the United States will save more domestically (not all bad if you ask me). But ultimately, what they decide to do with those pieces of paper is their business and is not going to sink the U.S. economy.

Many of the arguments in favor of a bond bubble can be debunked by reviewing the hyperinflationist argument over time. For instance, in January of 2009 The Telegraph had a provocative piece titled “The bond bubble is an accident waiting to happen“. The author, Ambrose Evans-Pritchard, said the bond vigilantes were asleep and that China and Japan would soon stop funding the US need for debt:

“The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.

It is lazy to think that China, Japan, the petro-powers and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.”

The only thing that appears lazy in this whole argument (aside from the argument itself) is the bond vigilantes, who, 18 months after this piece was penned, just refuse to wake up! Unfortunately for Mr. Evans-Pritchard China has already begun reducing their holdings of treasuries and the bond yields have continued to tick lower. He went on to describe how Mr. Bernanke was about to be the cause of horrid inflation and how we weren’t at all similar to Japan:

“Investors have drawn a false parallel with Japan’s Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.”

Unfortunately, that nuclear option did not prove inflationary at all and we are looking more and more Japanese by the day. Although the Fed’s actions changed the composition of bank balance sheets and helped trigger a mean reverting move in some asset prices it has not caused even one iota of inflation. In fact, recent data shows that the private sector appears to be at serious risk of retrenching and could take prices down with it. In a de-leveraging cycle, the Fed has far less control over the money supply than many presume. Bernanke’s great monetarist gaffe was based on this idea that saving the banks would save the economy which would save the private sector. But that has been proven entirely false as Bernanke’s focus on saving the banks has actually translated into very little private sector good. Without a steep acceleration in borrowing I would argue that Mr. Bernanke has failed entirely. Hence, his frustrating battle with disinflation (and risk of deflation).

Some market participants have gone so far as to compare the U.S. bond market to the Nasdaq bubble. This is simply not a fair comparison. The Nasdaq declined 90% from peak to trough. If you buy a 10 year government bond and hold it to maturity you will receive your principle back in full in addition to the coupon payments. If inflation jumps from the currently low levels to 5% you will be sacrificing 2.5% per year in real terms. Certainly not a winning pick, but nowhere near what the apocalyptic results of the Nasdaq bubble were. To reinforce this point I would highly recommend reading this paper from Vanguard which nicely summarizes the risks of the current low rate environment:

“When evaluating the potential risks in the bond market, it is critical to remember exactly why bonds are an integral part of a well-thought-out asset allocation plan—to diversify the risk inherent in the equity markets. Simply put, while the fear of rising interest rates may be legitimate, a potential bear market in bonds is dramatically different from a bear market in stocks (or other risky assets). In fact, unlike stocks, where the common definition of a bear market is a 20% decline in prices, to most investors a bear market in bonds is simply a period of negative returns. And to date, the broad U.S. bond market has never experienced a –20% return. Indeed, it’s the magnitude of returns that is the key differentiator between bad periods for bonds versus stocks. For example, the worst 12-month return for U.S. bonds since 1926 was –9.2%, while the worst 12-month return for U.S. stocks was –67.6% (12 months ended
June 1932).

In another example, the worst calendar year for the broad bond market was 1994, when due to an unexpected upward shift in interest rates, the bond market returned –2.9% (in 1995, the bond market returned 18.5%). Contrast this to the experience of stock investors in 2008, when the Standard & Poor’s 500 Index lost more than –2.9% in 27 individual trading days.”

When it comes to this whole debate the most important factor is the mere reality of our economic plight. As we all know by now, we are currently confronted with the threat of deflation, 9.5% unemployment, 74.8% capacity utilization, falling home prices, durable goods orders that are more than 20% from their peak levels, rising unemployment claims, equity prices that are 30% from their peak and high historical private sector debt levels. When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad. Perhaps not the best bet in the world, but irrational? Certainly not. As Vanguard says, when compared to the long-term growth potential of equities bonds currently look like a fairly good hedge.

So, you can see that it is not accurate to describe the U.S. government bond market as even remotely comparable to the “bubble” occurrences we have seen in other asset classes throughout history. Even at its worst “valuations” the U.S. government bond market has performed relatively well when compared to the well known “bubbles” of history.

In summary let us remember that a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. These characteristics are not currently attributable to the U.S government bond market. Given the economic environment (and potential outlook for equities) it is not irrational for investors to seek a very safe interest bearing asset in a time of high uncertainty and 0% interest rates. In addition, as shown in the examples above, it is highly improbable that the US government bond market will collapse. Lastly, while bond investors might be susceptible to losses history shows that it is not accurate to imply that they are susceptible to a “collapse”. 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.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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