These Market Bubbles Are Brewing

Central Banks and governments have cooking up a rich primordial soup that should yield a few good bubbles in 2011 and beyond. However, these bubbles are still nascent and therefore hard to detect.
Let us turn our attention to existing market dislocations that may not qualify as bubbles, but nevertheless have the potential to dish out large losses to investors.
The chart shows the yield of a 30-year treasury bond since 1977. It has been declining since the early ’80s. Anyone who bought bonds during the last 30 years received the interest payments, which are the main reason for buying bonds. They also saw the value of their holdings increase because bond prices go up when yields go down.

Because bond investing has been so much fun thanks to this 30-year tail wind, people have piled into bond funds. Bill Gross’ Total Return Bond Fund is now one of the largest mutual fund in the US.

While I haven’t heard anyone bragging about their bond investments at parties, the other aspects of bubble formation are present. People have shifted assets into bonds, people buy bonds on credit, etc.

The thing is, interest rates can’t go down indefinitely, because they can’t drop below zero. In fact, it seems unlikely that they will go down much from where they are now. 4.5% is not much yield to lend money to the government for 30 year.

So what happens when interest rates go back up? The average yield since 1977 was about 7.5%. The price of a newly minted 30-year bond would drop by approximately 35% if rates went back to 7.5%. That’s a pretty hefty decline for a ‘safe’ investment.

But is the scenario realistic? I think so!

Long-term inflation in the US has averaged around 4%. There is no reason to think that it will be lower for the next 30 years. Investors will demand at least 3-4% above inflation to lend money to anyone, just as they are doing now with inflation around 1% and 30-year yields around 4.5%.

And then there is the deficit.If Washington doesn’t get this under control quickly, the credit rating of the US will suffer and lenders will demand higher yields.

It is easy to argue that the US bond market is not a bubble. The current low yields are the result of many factors besides speculative frenzy. Interest rate policy has something to do with it. So does the natural tendency of investors to flee to the supposedly safe bonds when the stock market goes crazy.

The main reason why people don’t like bubbles is that it hurts when they pop. It is almost certain that interest rates will go back to more normal levels eventually. History shows that this often happens fairly quickly and even a relatively modest move will cause large declines in the values of long-term bonds. There is plenty potential for pain and very little up-side in the bond market. That is exactly what one would expect near the peak of a bubble, even if the way we got to this point doesn’t exactly follow the way bubbles normally form.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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