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. 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 as the market itself is designed solely as a monetary tool. 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.
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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124 Comments
Hugh Hendry agrees. He thinks bond yields can go to “”outraously lows”".
do you have a source for that quote? or are you familiar with hendry’s macro outlook?
I’d be interested in his latest also. If I’m not mistaken he is calling for deflation and then inflation, right? I might be wrong….if a reader knows that would be great. Thanks.
My personal opinion is that Quantitvie Easing (=monetizing debt) pushes interests rates much, much lower. Banks don’t lend, they hoard the cash in the form of T-bonds.
But there’s a flipside: When (not if) the banks go belly up in droves then those bonds will be flooded onto the markets and that WILL push interest rates up (VERY) high(er). Keyword: “”crashing”".
And that’s the most dangerous inflection point: How are the central banks going to respond to that situation ? Is e.g. the FED going to Hyper-monetize US debt ? And at that point (hyper-)inflation could be kicking in.
“But there’s a flipside: When (not if) the banks go belly up in droves then those bonds will be flooded onto the markets and that WILL push interest rates up (VERY) high(er). Keyword: “”crashing”.”
I don’t understand how that will happen. A bank is called “failed” and taken over by the FDIC when it has insufficient capital (of certain kinds). That means its liabilities (including customer deposits and bank debt) exceed its assets (reserves, issued loans, and including Treasuries). Like a bankruptcy, the FDIC wipes out bank equity, sells the assets & operational liabilities including customer deposits to another bank, and uses the proceeds to repay at a discount the failed bank bondholders.
The customer deposits are offset by loan assets and Treasuries/Agencies. The new, purchasing bank can’t dump those unless it either already has a Tier 1 capital surplus, or reduces customer deposits or bank debt. In either case, any “dumping” of Treasuries by the purchasing bank onto the market (reducing price, increasing yield) is offset by similar reduction of bank liabilities (a deleveraging event, which increase demand for safe Treasuries, decreasing yield).
You’ve just said it ! In order to pay the bondholders/debtholders the bank has to be liquidated, the assets sold. i.e. the T-bonds are to be sold and that pushes interest rates up.
That’s all assuming that the rest of the world doesn’t drive bond prices up when they panic (reference Q4 2008). Which is exactly what would happen under that sort of scenario. We keep seeing it time and time again. Every time there is a credit flare up treasuries soar. It’s the exact opposite of what every hyperinflationist told us would happen.
TPC,
Here are the latest comments I’ve got from Hendry. Still firmly in the Deflation camp, with a side of “China’s going down”.
http://www.marketfolly.com/2010/05/hugh-hendrys-eclectica-fund-sees.html
You knew there was no bond bubble the second Jeremy Siegel wrote an article saying there was one. Like Greenspan, this man has based all of this life’s work on a flawed model.
I don’t know how you can write such excellent pieces day after day.
You can also point out that those “reserves” held by the East Asian central banks are matched by a similar amount of “currency stabilization bonds” that are issued by the central bank. Therefore the PBOC may have $2 trillion in reserves but they also issue the equivalent of $2 trillion in RMB bonds. This is necessary to mitigate the inflationary effects of printing your own currency for dollars.
So since the PBOC has reserves of $2 trillion, it also owes the equivalent of $2 trillions to its citizens or probably its financial institutions. If China destroys the value of US Treasurys, then it will be stuck with $2 trillion worth of RMB debt with worthless reserves to pay it off. However no one really talks about the precarious situation the Asian Central Banks are in with their debt that they have issued, because it isn’t in such a situation.
Perhaps to get the people off its back about how China can dump US Treasurys, and to retaliate against mercantilist asian currency policies, the Fed can start accumulating trillions of dollars worth of RMB reserves and issue “currency stabilization bonds” of its own. It would probably be great for US manufacturing.
Also comparing US Government bonds to currency stabilization bonds would help the understanding of some of your readers..
I have watched a series of three very interesting videos with Hendry.
http://www.ft.com/cms/893ac9c8-757e-11dc-b7cb-0000779fd2ac.html
Look at the right hand side of that page and search for july 5, 2009.
And Hendry is NOT bullish on China !
I can recommend to watch the three videos on that same webpage with Michael Pettis. Look for september 21, 2009, M. Pettis. Although he’s not so outspoken as Hendry, Mr. Pettis shares his view and he can explain why China is vulnerable as well.
“An old rule of thumb is that real yields are a proxy for expected real growth,”
A proxy for the real yield (interest rates minus the inflation rate) is the 10-Year Treasury Inflation Index note.
Or the 10yr treasury minus the annualized PCE
If this holds up expected real growth is in the range of 1.5% to 1.75%
Consequently if real growth is 1.5 to 1.75% it is not Bonds that are in a “Bubble”
One shouldn’t look at the nominal interest rate only but at the REAL interest rate (Nominal rate minus In-/de-flation) as well. And then REAL interest rates are already at some 7%. And that’s high.
“One shouldn’t look at the nominal interest rate only but at the REAL interest rate (Nominal rate minus In-/de-flation) as well. And then REAL interest rates are already at some 7%. And that’s high.”
Maybe for junk at long duration. For Treasuries, the 10-year is at nominal 2.6% less maybe 0.5% implied inflation, yielding 10-yr risk free REAL rates of around 2%.
No, REAL rates for T-bonds are also higher than the nominal rates of those T-bonds. Not at 7% but higher than the nominal rate of about 2.5%.
There is something strange about the way the bond bubble terrorist operate. It seems to me that if we had the present poor economic conditions and the ten year treasure yield were at 6% instead of 2.6% they would be pointing to the yield to back up their forecast of government insolvency. Instead, they call it a bubble. Why do they not point to the low yield and ask if the bond market is really indicating deflation? (This is not to say I believe any market ever tells us anything.) But, if those people are so afraid of the US bond market they can always take their money and put it in German stocks. We all know that once the Germans impose their austerity measures the economy is going to boom. Right.
going on record here with this: i will be heavy shorting sometime in october.
october 1932 here we come.everything is in a line.
the signals are too long to list, & i’m not into a “how bout this n that” debate.
ya’ll write this down n i’ll take my lumps if i’m wrong……
i would rather have lumps than the depression i see coming.
You will be shorting equities or bonds, Boatman? Just so we have the record straight =)
I would tend to agree…..but it’s already a much more crowded trade than you lead others to believe.
Excellent information/website TPC, thanks for the education.
You didn’t mention the leverage in the bond market though… there are tons of players buying bonds on leverage, therefore it is possible for bond prices to be driven up by leveraged buyers.
And while the funding rate may ‘remain low for an extended period’, if these leveraged players became forced out on losses following a rise in yields due to better economic data say, this could revert bond yields to more ‘normal’ yield levels.
So the question really is, like most bubbles, what are the speculative/fast money/weak hand positions like? IMO – probably still small short given the crazy talk out there of inflation/hyperinflation. At the lows, we will be screaming about deflation, not debating it.
I’ve made quite a tidy sum from bond funds this year, and it’s all down to reading your essays. Thanks!
Great article TPC
I read about the ‘bond bubble’ no less than 5 times today – in australian publications! Crazy.
What about TIPS? Shouldn’t those that are worried about inflation or sudden miraculous revival of the US economy invest in those?
Thank you TPC
I have spent the a great deal of time these past 18-months educating myself on finance and economics.
The issue isn’t whether the primary bond auctions will fail — they obviously won’t. The issue is whether those who participate in the secondary market are paying too much, and if so, why and for how long.
Hedge funds have recently been diving into treasuries: http://www.marketwatch.com/story/hedge-funds-pile-into-treasury-bond-market-2010-08-11 It’s fair to surmise that by dog piling into the secondary market that they are distorting it.
It would seem that those who have been fearing bond vigilantes have the story backwards — they aren’t pushing down yields, they are driving them up. Unlike traditional bond buyers, who are buying treasuries for downside protection and to hold cash, these guys are playing the greater fool theory on the yield, and will head for the exits as soon as they figure that the jig is up.
It is a bubble, in that these low rates are not likely to be sustainable, the short-term pricing isn’t based upon long-run fundamentals, and the holders of bonds are going to end up getting stuck with the opportunity cost that comes with low yields.
The current yield makes sense only if you believe that the United States is diving into an economic deep freeze. This yield makes no sense whatsoever for anyone who expects even a semi-normal recovery with nominal inflation. One need not be an inflationista goldbug to see this.
No, it isn’t a bubble to the extent that this won’t result in a wipe out of those who overpaid, but that isn’t the point. Those buyers will have left plenty of money on the table by saddled with low returns that, over the long run, will barely exceed what they could have made had they just left the money in a savings account. An investor who buys a 10-year at 2.6% today, only to sell it later at 3.5% or to miss out on a market opportunity that pays 7-8%, will have either lost money or else not earned as much as he could have.
Oops, to correct a typo: “It would seem that those who have been fearing bond vigilantes have the story backwards — they aren’t pushing up yields, they are driving them down.”
This whole silly argument is based on the false idea that you might invest your entire life’s savings in bonds TODAY. I say reinvest the dividends over time, buy some TIPS, diversify and go back to sleep. There is no bubble in any terms. As I concluded, using such a term to describe an investment that matures at par is utter nonsense. This bond bubble chatter has been going on for many years and anyone who has been building bond portfolios over time has made enormous profits. And my guess is that the prudent bond investors will continue to invest in govt bonds – even if yields begin to rise. It’s called investing. Not placing a one time bet on black.
This whole silly argument is based on the false idea that you might invest your entire life’s savings in bonds TODAY.
Actually, no, that isn’t what is being said, and you need not misstate the argument.
It’s really pretty simple: If yields go up within the next several months, those who locked in low yields at today’s prices will have underperformed on today’s purchases.
I am going further, and looking at who is doing the buying. And was the case with the oil bubble, it would appear that the secondary treasury market is being increasingly influenced by traders who are trying to capture falling yields over the short term, rather than true hedgers who are simply buying in order to diversify risk.
Like the commodities market, the primary purpose of these long-term bond markets is to provide safety and hedges. But like the commodities markets, there are periods when the buyers become more aggressive. Those aggressive buyers tend to overpay, because they aren’t in the market for the long haul.
Not everyone is in either the extremist deflation vs. inflation camp. I personally belong to neither; I see the “square root” recovery that I’ve mentioned here previously to be continuing, which tells me that the current rates are an aberration.
At the same time, I see a different buyer pool with different objectives jumping into this market, which is an additional indication of instability and dysfunctional short-term price discovery. These yields are not sustainable, just as they weren’t sustainable when the 10-year almost touched 2% in December 2008.
We’ll revisit this in a year. If you see that 10-year yields are back into the 3′s or possibly 4′s as I expect, then you’ll know what I’ve been talking about. That isn’t a wild inflation scenario, it’s a call that we aren’t tumbling into a deflationary abyss (although it’s not a bad idea to hedge for that risk; that risk exceeds the risk of inflation). It isn’t all so black and white.
Why in the world would we judge the overall performance of the 10 year treasury one year from now? My whole argument is based on the idea that if you’re buying a 10 year treasury today you should hold it to maturity.
If I were making a trading call here (as I did when I top ticked the bond peak on 2008 AND the bottom in 2009) I would say that explicitly. http://pragcap.com/revisiting-the-bond-trade-of-the-year
This post has nothing to do with trading bonds. If you want to judge it in 10 years then be my guest, but please don’t skew the time frame just to make your argument look better.
My whole argument is based on the idea that if you’re buying a 10 year treasury today you should hold it to maturity.
And one of the counterarguments to that is that the return on that will prove to be lousy over the long run. On a real net-inflation basis, that could prove to be zero or negative, even if you just anticipate nominal, reasonable inflation. Current yields are well below historical averages, so a simple reversion to the mean would correct these rates to higher levels.
But again, my central point is that it would appear based upon (a) the increased participation by traders in this market and (b) greater intraday price volatility that traders are pushing down yields over the short term. At this point, the treasury market isn’t just about safety and diversification as it usually is; there is some sort of reverse vigilantism, with traders using these to play the deflation/ Euro collapse scenario for short-term gain.
The bond markets are supposed to be wiser than equities, and they often are. But here I suspect that the bond market has momentarily lost its head. It happened in December 2008, and it seems to me to be happening again.
Now, if the deflation/ implosion scenario proves to be correct, then my assessment will ultimately be wrong. But unlike you, deflation for me is just a possible alternative risk to be hedged, not a base case assumption — we simply disagree on that point. I am obviously not an inflationist extremist by any measure, so that sort of left-field bias does not influence my position.
(Apologies for the italics glitch in the last post. Multitasking doesn’t help my editing…)
TPC,
We have already experienced a lost decade in equities and we are (in my opinion) already 4 years into this credit meltdown. What do you mean we won’t see another lost decade?
You and Angry are both right. Actually, Angry, for the first time, is on the right side of the debate. Wasn’t sure if I could write that? Ok, so both of you ASS-U-ME that the US is going to claw its way out of this mess in a relatively short period of time. This will prove to be both of your demise.
The time it takes for the current debt to default or payoff must be increased exponentially or we will languish in no-man’s land for several decades to come. The red lights and sirens are flashing ever brighter and sounding ever louder in the minds of the American public as they begin to recognize that these Keynesian efforts are nothing short of a scam by our Fed Chief, Treasury and some elected officials to save the banks at the sole demise of the American public.
I am actually enlightened by the current downward spiraling of economic indicators. This offers a glimmer of hope to those of us who merely want to see the misallocated malinvestments move from the performing loan portfolio accounting column to the foreclosure and liquidated asset columns. Rates will stay where they are or move lower until the aforementioned occurs. Didn’t the 10 year get to 1% in the 30′s?
As far as bonds collapsing? Anything can collapse if an overwhelmingly percentage of the participants loose confidence in the bonds.
The whole point here is to show that it is very misleading to imply that the bond investor could somehow lose an extraordinary amount of money. It’s pure and simple fear mongering based on misconception. We all know bond prices fluctuate and you can suffer losses at times if you don’t hold to maturity, but this whole implication that a 10 year treasury is somehow in a bubble implies that there is extraordinary risk in buying bonds these days. That’s simply not true. Are the risks perhaps elevated? Perhaps. But even your worst case scenario here is likely to be FAR better than the bubbles we’re all familiar with….
We generally agree, but for the fact that my degree of optimism is just slightly higher than is yours. This seems to be a difference in semantics.
In your view, a “bubble” refers to a combination of pricing being out of whack and the deep losses that follow the resulting crash. Those who are in my camp are using “bubble” to describe the disconnect in the pricing mechanism, not necessarily the outcome when that corrects.
There are some goldbug wackos who believe that treasuries are going to evaporate, of course, but those folks are outliers on the fringe. I wouldn’t take them seriously.
In contrast, there are at least a few of us out here who just believe that mid-2′s yields on 10-years don’t make much sense. I refer to this pricing and the underlying causes as a “bubble” with the implication that intelligent people already know that the US isn’t going to melt into a ball of hyperinflation. I just don’t see much reason for a retail investor to lock in rates like these or to overweight them; that reflects my view that deflation is a risk, but not likely.
“No, it isn’t a bubble to the extent that this won’t result in a wipe out of those who overpaid, but that isn’t the point.”
It will be a wipe out if the dollar in principle bondholders receive when their bonds mature are worth 10 cents in current purchasing power when they are paid.
TPC, totally agreed, bond yields will go down lower and will keep surprising everybody. Regarding Hugh Hendry: he made a call that the U.S. should prepare for hyperinflation after deflation deepens, here is the link:
http://www.zerohedge.com/article/hugh-hendry-warns-prepare-hyperinflation
“due to mass misconception of the way the bond market actually operates and this propensity to label everything as a “bubble”.
When you borrow you have to pay interest
When the interest payments exceed an amount you can afford to pay you DEFAULT
We will default or restructure
“We will default or restructure”
Which is what everybody keeps saying, but actual money invested tells a much different story. So it’s your belief in a future conditional, against a present reality believed by the entire world’s capital.
You must believe you can time the market, are a better long-term investor than average, and can front run the global bond market. I’m assuming you have a long-term short position in Treasuries, then – good luck to you.
Good comments Steve. Thanks.
TPC
Good comment my ass and this article is once again more ponzi finance sophistry.
“Oh the Nasdaq is at 2500 and up 3% for the day, no bubble there!….Oh look 3000 now and people are still buying, there’s no bubble!….ohhh look 5000…………”
It gets worse when you use the same logic with a QE rigged bond market
Oh I forgot because “we dont really borrow, we dont really owe anyone, we can never truly default because we print our own money”……as per your other articles.
Ponzi sophistry all of it, you and Galbraith should get a room
Andy,
Do you mind if I call you Andy or would you prefer to remain anonymous? How does a country which creates its own currency not afford interest payments? This is like saying that an alchemist is going to run out of gold. Can you explain that to me in great detail?
As an aside – my tolerance for even borderline trolling like this comment is growing VERY thin. I am not a website moderator and I refuse to let the commentators abuse this space, myself or other users and waste my time while they fulfill some sick insecurity or anger. If you don’t agree then tell me why. Engage me. PROVE ME WRONG! But don’t act like a child. Act like an adult and clean up your comments and if you can’t do that then don’t comment at all. I’m a nice guy, but there is only so much I can put up with.
Thanks.
I signed my name to that post just like the previous one I was responding to as far as I know but yes you may call me Andy.
“How does a country which creates its own currency not afford interest payments? This is like saying that an alchemist is going to run out of gold.”
See what I mean by sophistry, sure technically the government can print as much money as they want to pay debts and interest as everybody knows, of course if the government were to do so the money would be worth about as much as the alchemists gold in TPC’s example
Weimer Germany may have never officially defaulted on their bonds “technically” but that didn’t work out too well for them in the end.
So saying that we can never default on our debt because we can simply print money is just sophistry, also if we cannot simply print money then all of your other arguments are invalidated because they all hinge on the ability to print an endless supply of money without consequence.
“As an aside – my tolerance for even borderline trolling like this comment is growing VERY thin. I am not a website moderator and I refuse to let the commentators abuse this space, myself or other users and waste my time while they fulfill some sick insecurity or anger.”
Krugmans censoring his blog now too I hear, must be catching
I feel the ban stick coming
Why would I ban you for a perfectly reasonable comment?
Let me follow-up though. You imply that we can just print excessive amounts of currency. okay. So let’s connect the dots. If we’re printing excessive amounts then we must be seeing a devalued currency? Nope. We must be seeing very high inflation. Nope. We see only signs of deflation. So your whole argument falls through the roof right there. This is just classic hyperinflationist nonsense. You guys put all your chips on the idea that the Fed’s actions in 2008 would wreck the dollar, but it’s just been horribly wrong. All of these websites and pundits who have been chirping about inflation have made one of the worst calls in market history…..
What your saying is the same thing they said at Nasdaq 3000 and 3200 and 3500 and 4000……”look it keeps going up, you guys with your “markets in a bubble nonsense” have made the worst call in years……..”
In 2004 I heard same about the housing bubble “Oh you keep saying housing is in a bubble and its going to crash but look home prices are up again this year….bad call again”
When we can no longer service the interest on our debt and creditors stop lending to us we will default, restructure, or destroy the value of the US dollar by printing it to try and pay.
I predict this will happen by 2016….good luck owning TIPS and Treasuries when it does.
Andy, you’re sidestepping my question. As I said earlier, the alchemist is never out of money. If he makes too much gold then he creates inflation. But where the is the inflation that our alchemist Mr. Bernanke has created? You can’t keep arguing that we can’t pay our bills when there is neither an actual default or even a pseudo default (hyperinflation). And yes, I’ve been listening to this hyperinflationist argument for years now: “just you wait TPC. Just you wait. It’s coming! Once those bond vigilantes wake up!”
But where the is the inflation that our alchemist Mr. Bernanke has created?
It’s interesting that there has been increasing repudiation of the efficient market hypothesis, while people have been much slower to recognizing another theoretical failure that may even more useful: the quantity theory of money is flawed, too.
It should be really obvious right now that the creation of more currency does not, by itself, result in inflation, at least under certain circumstances. There are already real world examples of when governments have printed money without causing high inflation, so this point isn’t just a matter of speculation but absolute fact.
Part of what you’re seeing is the unwillingness of the internet Austrian types to recognize that one of their core beliefs is utterly wrong. They take quantity theory to an extreme, and don’t want to let go of it, as it is a basic principal of their faith. And since many have fetishized that theory into a religion of sorts, the last thing that they want to do is to accept that it could possibly wrong, or at least not as linear as they would care to believe. You’ll have an uphill battle trying to break through that mindset…
“the alchemist is never out of money.”
Like I said your arguments all hinge on Ponzi financing
Another thing, the bond bubble bursting is a macro call and most of the commentators that Ive seen such as Dr Marc Faber have made this a 7 to 10 year call. Ive never seen anyone claim they know exactly when it will blow up just that they are sure it eventually will…….and it will
Governments cannot just endlessly issue bonds and pay for them by printing money because if they could we would all be living in a Ponzi Utopia.
20 trillion by 2016 possibly 30 trillion or more by 2020 and no hope of any economic expansion so where will the money come from to service the debt?
They can never pay these debts so they will repudiate them or destroy the currency or take us to war.
Very peculiar analogy by the way, comparing Bernanke to an alchemist but actually fitting because alchemists create fake worthless gold and Bernanke creates fake worthless money, when it becomes apparent to everyone that the money is worthless then the bond bubble will burst that will happen when the debt service payments exceed our ability to pay which I believe will occur in 5 to 10 years
All you have to do is watch the numbers roll up
ponzi finance? You’ve been reading the wrong websites my friend. All those guys chirping about hyperinflation and the collapse of the dollar. The collapse of bonds, etc. They haven’t just been wrong. They should have zero readers because they’ve entirely discredited themselves. They’ve made one of the worst calls in the history of markets.
I am trying to respect your question, but you’re not actually explaining why I am wrong. You just keep repeating the same thing over and over. You say that we will default. You say that we will print too much. But if there is no inflation and there is clearly no imminent signs of default then where is your argument faulty? You don’t seem to see the flaw in your argument. Something is missing….
I tend to tune out any comment that resorts to using these hollow cliches such as “Ponzi”. The jargon tells us more about the mindset of those who say it than it does about the system itself.
A modern economy is like a shark; if it stops moving, it dies. If you want prosperity, the wheels of output need to keep turning. That shouldn’t be that tough to understand, and there is nothing outlandish or Ponzi about it.
“So it’s your belief in a future conditional, against a present reality believed by the entire world’s capital.”
The entire worlds capital have believed in many a bogus present reality over the years only to have their beliefs shattered so excuse me if I don’t share in the entire worlds capital belief system.
They were predicting 20 trillion in debt by 2020 a year and a half ago now they are talking about 20 trillion in debt by 2015/16
I will make the bold prediction that they will be predicting 25 trillion by 2016 soon……give it a year or two
Never a word of paying any of this down either, so what will the actual figure be in 2020?
30 35 40 50 trillion?
In the first 2020 projection they were anticipating something on the order of 800 billion in interest expense @20 to 21 trillion of debt so what will the real figure come to 1 trillion 1.5 trillion 2 trillion?
Not doable
People are scared, and piling into bonds. Risk profiles have been altered, and fixed income fits the bill for many now. Unfortunately, this safety comes at a price – namely, upside.
2.5% returns in treasuries would make someone 65 years old sleep well at night, but someone 30 years old should tremble while holding the same paper – because they(should) have different risk profiles.
I’ll take my chances with the MSFT’s, BP’s, and VZ’s of the world. 2-6% dividends, 20% per share in cash, a decent (but not great) multiple – and god forbid anything good happen…
But I don’t blame retiree’s for piling into treasury paper,but I’ll take the upside bet thankyou very much
There is a certain “catch 22″ logic between the bond market, the Chinese purchasing of US bonds, and the US economy. Yes, as long as the US economy does not collapse, we will keep buying goods from China in return for paper dollars. China must do something with the mass quanties of dollars and has built mass stockpiles of commodities, spent huge amounts of money on infrastructure including building unpopulated cities (Choungong, forgive spelling), and used the remainder to buy US bonds.
However, the bond market is predicting deflation and economic collapse. If the US economy or currency collapses, we can no longer afford to buy (as much) Chinese goods, in turn they buy less US bonds and our interest rates rise, our economy collapses more, and we enter a death spiral.
In case you all missed it Rosenberg had a nice response to the Siegel article as well:
https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_081910.pdf
Barry Ritholtz also wrote a follow-up which graciously offers both sides of the argument:
http://www.ritholtz.com/blog/2010/08/bond-bubble/
I guess MarketWatch doesn’t follow pragcap!
“It’s just that no one knew when or how it would manifest itself. Same thing is happening right now with the bond bubble”
http://www.marketwatch.com/story/big-investors-pulling-the-exit-chute-beer-in-hand-2010-08-19
TPC I partly agree with your analysis. If you hold a bond until maturity you incur small relative losses (in an inflationary environment). However most private investors are invested in bonds through mutual funds which invest in a variety of bond maturities. Hungry for yields these fund managers are now chasing long term bonds. If inflation comes back, these managers will run for the exit and not wait until their 10-y or 30-y bond matures. They will take a a signifcant hit as bond prices collapse and investors who thought that bond funds are secure will have a rude awakening. This is how the “bubble” will burst.
Don’t these funds just constantly roll over the debt though? They’re basically dollar cost averaging into various maturities so it’s really not that different than buying the actual bond. They should revert around some mean over the course of their duration.
I must say that my outlook on bonds is more bearish than “investors may suffer moderate losses if they hold their bonds to maturity”. Let me explain:
-> While fundamentals for sovereign nations have deteriorated (more debt, bigger deficits), issuance of sovereign bonds has soared (directly, or indirectly via a bailout)
-> This has been more than matched by an unprecedented interest in buying sovereign bonds. But lots of the buyers are just there because it is the path indicated by the fed of transferring private wealth to the insolvent financial sector
-> Once the banks have been nursed back to health and the economy has adapted to the new environment other investments will appear more attractive
Much or all of the following will occur:
-> Lots of sovereign debt will need to be rolled over, with the occasional bump (expiry of some guarantees appears to create these anomalies)
-> It is unlikely that the primary balance of the government will already be positive at that point, so some more borrowing will be required
-> Cheap bank funding at the taxpayer’s trough will end once the banks are deemed solvent
-> Some countries will end up in a debt death spiral, some of them will default, thus altering anyone’s risk assumptions on sovereign bonds
-> Printing money (i.e. massive direct debt purchases by the treasury) will be a political non-starter, because by now everyone knows that the republicans will make government budgets their main theme in the next presidential elections
So, once 10yr auctions get yields of around 6%, at what price could you expect to sell a bond with 8yrs left on it and a coupon of 2% or 2,5% (yes, I don’t think we’ve seen the lowest yet). Holding it to maturity wouldn’t make it any better either. The money that is now sitting at the banks is going to be set free at SOME point. We just don’t know yet when and what it will flow to.
There is a formula for this, I know, I’m sure someone cleverer than me can calculate it.
You simply couldnt have it more wrong.
I hope you are not investing your own money.
Anyone reading this website over the last few years will notice that TPC has been remarkably correct in almost every macro and micro call he has made. He has tirelessly destroyed the arguments of the hyperinflationists and so far he has been very right. Unless hyperinflation somehow occurs here in the USA or the country defaults he will again prove correct.
I get plenty wrong. I can guarantee you people will come back in 12 months if the yield on the 10 year is at 4% and say: “ha, you are an idiot”. Translation: at this pace I am set to lose a whopping 1.5% in real terms per year on my bond. Big deal. Average in, buy some TIPS, get some sleep. Rinse, wash, repeat.
Translation: at this pace I am set to lose a whopping 1.5% in real terms per year on my bond.
The losses would be substantial for those who overpay, but then later exit prior to maturity. In the alternative, there would be lost opportunity for those who kept investment cash parked in the 2% range when that cash could have otherwise been available over the next ten years for superior alternatives.
Again, I don’t see very many qualified people, beyond a few extremists, who are calling for an actual collapse of US treasuries. True, I see a lot of those sorts of sentiments in the comments sections of business blogs, but they are a fringe as well. Virtually none of those posters trade their own account, let alone manage other peoples’ money or move markets.
TPC,
In what scenarios do you see hyperinflation occurring? Thanks.
I’ll write a piece on hyperinflation some time in the next few weeks. I don’t know if there is a term that is thrown around more inappropriately. But to answer your question quickly: it could happen if the USA falls into a black hole and economic output falls to 0%. And don’t confuse the 70′s with hyperinflation. That was largely an oil shock. It was high inflation, but not hyperinflation. Could that happen again? I seriously doubt OPEC will try those shenanigans again.
There could be another oil shock coming from natural depletion. Peak Oil hasn’t hit us since the recession cut global demand, but it could easily hit within the next 10 years. A lot will depend on how quickly Canada ramps up production of tar sands, and how quickly other oil producers fall off. Since a lot of soverign producers in the ME don’t give out accurate information as to their true reserves and production, it is hard to know how quickly those sources will disappear. If renewed recession hits harder, that could delay the oil shock for some time – especially if China goes into recession.
TPC,
What do you think about the fact that bonds have been in a secular bull for nearly 30 years. Do you have any concerns about the rally getting a little long in the tooth?
Moses,
Good question. The average historical rate of inflation is roughly 3%. Barring some catastrophe or incredible economic boom it’s likely that rates will stay in that range for some time. I think the USA is maturing as an economy. The days of high growth are largely behind us. We are more similar to Japan than many presume in this regard. So I would not be surprised if rates averaged 3-4% for the next 20 years. Benign inflation, moderate growth, generally boring economic conditions. But no collapse and no boom. If we get some sort of oil price shock or some rare exogenous event this yes, we could definitely see a spike in rates and I will look totally wrong, but that’s the world we live in – black swans happen.
What I don’t think will happen is a collapse in US bond market because we can’t fund ourselves. That’s absurd if you understand the monetary system we live in.
So, is the bond bull dead? No. I think people will continue to make safe returns in govt bonds for many decades to come. It might require some portfolio adjustment and diversification at times, but the govt bond market is not turning into dead money. As I said above, buys some TIPS, average in and get some sleep.
That’s just my opinion though. Hope that clarifies my thinking for you.
How long will the T-bond bull market last ? My personal view is four months MAXIMUM (!!!), NOT Years ! Then – IMO – both the price of the 10 and the 30 year T-bond WILL crash. Like they did in 1931 and 1932. And that’s the Keynesian endpoint for the US (to issue bonds !). And that’s where the rubber hits the road for the US. That’s where the US goes belly up. Then the US WILL be forced to cut spending.
When (IMO – not if) in the next two to four months prices of T-bonds go ballistic then the end game is in full play and then T-bonds are setting themselves up for a giant crash in, say november or december 2010 (!!!!)
And Hugh Hendry more or less agrees !
But I think that in november of this year there will be a GIANT opportunity for something different exciting !
A bond rate is the compounded rate derived from future expectations of overnight rates. In other words, to arrive at a yield, all one needs to do is to predict the Fed’s overnight funding level for the duration of the bond. Bonds are, therefore, anchored by the Federal Funds rate. The shorter the bonds, the more certainty one has with the Fed’s policy reaction function.
This is why the Fed uses the word extended. Since the word refers to at least the next six months, a holder of a one or two year note is mathematically assured of low funding for a substantial period of his bond maturity. The recent bond market rally has been driven from such short maturities as investors knew that the Fed will keep the funding rate at close to 0.20. This past week, the bond rally extended to longer maturities as the market concluded that the Fed will keep the low overnight rate for longer and will indeed buy more bonds to keep its balance sheet constant.
The bond market cannot be in a bubble unless the market’s perception of Federal Reserve policy takes a major u-turn. This is rather unlikely with GDP being so far below potential (lots of slack judging by the unemployment rate). The Fed bases its monetary policy on a concept of slack and so long as GDP is nowhere near 4%, it will be hard to close this gap in a hurry. The household sector is still too indebted to spend. The ratio of household debt to disposable personal income needs to drop to at least 0.90 before the consumer feels confident to borrow and spend. By my own simplistic calculation, it could be 2017 before the above ratio reaches the 0.90 level. A bond bubbles in this environment is most unlikely thanks to the Fed’s policy outlook.
Georges,
Great comment. Thanks for that. I would love to see your numbers on the debt outcome. I am on the same page as you, but my calculations lead me closer to 2012 or 2013 before the household sector is healed.
Thanks.
The fed fixes rate according to Inflation and not according to risk since there is no risk when you print your own paper.
The eventual risk is inflation and even if there is none at this time if you hold a 30 year bond until maturity and think that you will most likely only incur a small relative losses in an inflationary environment I think that this is a serious mistake. The Bond Market is like a dangerous animal when it is sleeping it’s all nice. With a few exception rate have basically been going down since 1981.
Most investors have never experience a long term bear in the bond market. It’s not rare that in one single day the Bond market devaluation equals one year of Interest income. After 30 years you will be paid in full (no default possible) but be prepared to receive seriously devaluated dollars. The only super safe place for fix income in time of serious inflation is very short term T bills. It’s like super safe no comission home made floating rate.
If you look at how the market performed in the last inflationary environment it is interesting to know that T-Bill did better than almost any investments until the market started to move up in 1981 at the end of the great inflation and the start of disinflation.
“The average historical rate of inflation is roughly 3%”
That is correct TPC but it’s those 0% and 17% exception that make life interesting.
TPC what would happen if the Fed had 0% or a negative interest rate on Bank reserve?
If they want the banks to lend why are they paying them interest to keep the money idle?
Maybe the Fed wants a controlled deflation to force the private sector to deleverage. The best investment you can make right now is paying down debt.
This would really be another misstep by the Fed. The idea behind negative rates is that you can incentivize the private sector to use its idle cash. But the problem is not excessive idle cash, but too much debt.
TPC,
The peak in the ratio was 132% in 2008. It has since come down to 124% (close to 5% a year). The denominator is relatively easy to forecast going forward as disposable personal income. What households do with the debt is a little harder to forecast. The recent drop since 2007 is unprecedented in nominal terms. If you use the way both have moved since the ratio peaked, I get 90% by around 2017. I am essentially extrapolating what happened since the ratio peaked (past two years) forward into the future and seeing when we hit 90%. Why that level? That is where the ratio was around 1997 and just before rising house prices and debt started to feed on each other.
interesting. I need to run my numbers again. Perhaps I am too bullish on the endgame here…
great analysis, i look forward to reading more from you……i have come up with the same timeframe by other indicators…….and the seat of my pants and the pit in my stomach, and my finger up in the wind.