Bond Bubble Fears are Overblown – Here’s Why.May 1st, 2012 by David Waring
The noise from those calling for a bond bubble has become so deafening, that it’s hard for even for the staunchest of buy and hold investors to ignore. Eventually the bond market bears will be right, but the only reason why, is that they have been willing to be so wrong for so long.
Here are 5 reasons why there is no bond market bubble and we are not likely to see significantly higher rates anytime soon.
1. The Japan Argument
The 10 year treasury bond is currently yielding less than 2%, so it’s easy to understand why the bond market bears think yields can’t go any lower. As Mebane Faber points out in his recent post US 10 Year Bond Yielding .5% however, the Japanese 10 Year Government Bond has gone as low as .5%, and has been yielding less than 2% for more than 10 years. The below chart where he compares the Japanese Government Bond’s descent to sub 2% yields, to the more recent descent in the US 10 year Treasury, shows the eerie similarities.
A Tale of 2 Sub 2% Decents
So is the US likely to have the same experience as Japan? There are some good fundamental reasons to believe that the answer to that question is yes, which brings us to our second reason why the bond market bears are wrong.
2. Stagnation, not Inflation is the most likely scenario
The next argument from those calling a bubble in bonds is that with all the government spending and increases in the Fed’s balance sheet, inflation is coming, which will force bond yields to rise substantially from their current low levels. The fact that the bears have been saying this for years and it has not yet happened, has only served to embolden them.
Hoisington Investment Management’s Latest Quarterly Review (h/t @munisrgood) gives us some good insights into why the coming years are much more likely to be characterized by stagnation than inflation. Their basic point is that the current massive increase in debt has not been used to finance productive assets, and is therefore having the opposite affect of what the government intends. Rather than getting the economy back on track for future growth, we are simply creating a debt service burden that will put a drag on the economy for years to come.
For those that make the argument that the huge amount of debt and fed intervention alone is enough to cause inflation even without a heat up in the economy, they point back to Japan:
“After repeatedly trying all of the Keynesian and monetary school recommendations on a large scale, Japan’s debt ratio stood at an all-time record 491% in 2011. Over this 23-year span, the portion of government debt to GDP ratio more than quadrupled, advancing from near 50% to over 200%…..Since 1990, numerous episodes of seemingly better Japanese growth failed to establish a self-sustaining recovery as debt’s negative feedback loops progressively worsened”.
3. Bonds have not sold off during the stock market rally.
Take a look at the below charts of the SPY ETF which tracks the performance of the S&P 500 Index, and the TLT ETF which tracks the performance of 20 year Treasuries. Since the beginning of the financial crisis in 2008, equities have rallied over 100% from the lows. At the same time bonds as represented by the TLT, are right back to about the same spot they were at the height of the crisis.
SPY Daily Chart
TLT Daily Chart
Normally you would see massive flows out of bonds in this situation as investors piled into the stock market, sending rates on government bonds skyrocketing. One obvious reason this has not happened in the current situation, is because the Fed has been such a large buyer of government bonds. However this still begs the question:
What happens when the next inevitable pullback in the stock market comes, the markets go risk off, and even more money comes flowing out of stocks and into bonds?
4. Supply is Shrinking at the Same Time Demand for Fixed Income is Increasing
In a recent piece in the Financial Times BlackRock’s Fixed Income Chief Investment Officer Rick Rieder shows that at the same time demand for fixed income is rising, the available supply is dropping. Like with anything else, increased demand and falling supply would indicate the exact opposite of the rise in yields the bond market bears are predicting.
Rick Rieder on the Fixed Income Supply Situation
“US financial institutions alone will reduce their debt by $360bn this year. Even the supply of US Treasuries is expected to decline. Gross US Treasury issuance in 2013 could be $1.9tn, according to Credit Suisse research, down 17 per cent from 2010 levels. And with the Federal Reserve purchasing Treasury bonds, net supply looks even more constrained.”
Rick Rieder on the Fixed Income Demand Situation
“….many companies are topping up their pension plan assets and shifting their allocation mix to fixed income to match their liabilities better. BlackRock expects US corporate pensions will put nearly $1.2tn into long-term bond strategies over the coming decade. US insurance companies may buy $600bn of bonds this year alone.”
5. You Can’t Have a Bond Bubble Without any Bulls
The last major argument that I hear from those saying there is a bond bubble is: “all you have to do is look at the chart to see that the treasury market is in a bubble that is about to burst”. As you can see by taking another look at the chart of the TLT above, if you go just by the charts, this is an argument that’s hard to counter. Unfortunately for the bond market bears however, the bubble argument is missing one major ingredient.
As you can see from the recent Barron’s Big Money Poll, when asked to “please specify whether you are bullish the Treasury market” only 2% of respondents said they were bullish.
Can you name me a financial bubble in history where if a similar poll was taken at the top of the bubble only 2% of respondents would have said they were bullish, and 81% would have said they were bearish?
Author of the Big Picture Blog Barry Ritholtz summed it up best in his recent post Who Hates Treasuries? Everybody! where he said:
“The problem is that we have heard it over and over and for nearly a decade. And, for nearly a decade, this call has been dead wrong. The long bond has had a 34% total return in the last 12 months versus a 5.1% return for the S&P 500 over the same period. The bond market has also outperformed stocks over the last 30 years for the first time since the Civil War.”