Weekly Markets Commentary

September 7, 2010

by David Joy

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A bond bubble, or justified concern?

There has been a lot of discussion recently as to whether the bond market is in a so-called bubble. Like home prices most recently, and technology stocks (particularly of the internet variety) before that, we have experienced major asset bubbles within the past decade whose bursting has caused widespread loss.

A bubble defined

There is some disagreement over the definition of a bubble, but it is fair to say that they are characterized by price or valuation that seems to have become detached from fundamental reason, driven ever higher by an emotional desire to own an asset that seems to do nothing but increase in value. Usually, this price action is accompanied by various explanations for why the gain is perfectly reasonable, and usually contains contrived justification to support the conclusion that things are different this time.

Former Federal Reserve Chairman Alan Greenspan has famously observed that bubbles are difficult to observe while they are occurring, but easy to see in hindsight. While that statement may have been somewhat self-serving as a defense of his relatively easy monetary policy, which some blame for igniting the housing bubble, it does contain an element of truth. If everyone agreed that a bubble was underway in a particular asset category, then presumably the marketplace would take the offsetting corrective action and the bubble would fizzle before it ascended to an extreme in price necessary to fulfill the definition. This brings us to the current state of the bond market and the question of whether a bubble has formed.

Follow the flows

The first piece of evidence generally offered to prove the existence of a bubble is the overwhelming amount and percentage of money flows that continue to be directed to the bond market, and away from equities. This phenomenon has been underway for the better part of the past 18 months, and continues at present despite the low level to which bond yields have fallen. According Bank of America Merrill Lynch, during the second quarter of this year, $43 billion of assets flowed into long-term taxable and tax-exempt mutual funds, while $6 billion was pulled from equity funds. So far in the third quarter the trend has continued, as an additional $29 billion has moved into bond funds while $9 billion has moved out of equities. These totals do not include exchange-traded funds (ETF) flows, which would result in a slightly better experience for equities in the second quarter but a far worse experience in the aggregate through the third quarter to date.

During this time, the yield on a constant maturity 10-year Treasury note has fallen from 3.83 percent to 2.71 percent, while the S&P 500 Index has declined from 1,169 to 1,104. If bonds are in a bubble, so far it has been rewarding, but then most bubbles are until they burst.

Two reasons are most often cited to explain these relative flows. The first is difficult to quantify, but generally relates to the damaged confidence among investors who have lost faith in equities after the most recent severe downturn. Coming so soon in memory after the downturn at the start of the decade, and resulting in a 10-year period in which the S&P 500 provide zero return, many investors have simply abandoned equities and opted instead for the more certain returns of bonds, as meager as they may be. Part of this rationale is the often cited view, especially among investors in or near retirement, that they cannot risk getting caught in another equity market downturn because they simply do not have either the time or the income to allow them to recover. Bubbles are most often associated with greed, but fear can also lead to their emergence and that sentiment likely explains at least part of the recent flows into the bond market.

Are prices/yields justified?

The second reason speaks directly to the question of whether bond prices/yields are explained by current economic fundamentals, thereby justifying the asset flows. The U.S. economic recovery has clearly slowed from its pace of earlier in the year. Second-quarter gross domestic product (GDP) grew at a revised annualized rate of 1.6 percent, down from 3.7 percent in the first quarter. Unemployment has remained stubbornly high at 9.6 percent, and 12-month consumer price inflation has fallen from 2.6 percent in January to 1.2 percent in August. The Philadelphia Fed's third-quarter Survey of Professional Forecasters now expects GDP growth of just 2.9 percent for all of 2010, down from 3.3 percent in its second-quarter survey. The forecast for 2011 has fallen to 2.7 percent from 3.1 percent. Consumer price inflation is now expected to run at a rate of just 0.9 percent in 2010, down from 1.6 percent; and 1.8 percent in 2011, down from the previous forecast of 2.0 percent. And the unemployment rate is expected to average 9.6 percent in 2010, unchanged from the second-quarter survey; and 9.2 percent in 2011, up from 8.9 percent previously.

If these forecasts are anywhere close to actual experience, it is difficult to argue that current bond yields are unjustified. The real, or inflation-adjusted, yield of the constant maturity 10-year Treasury note is currently 1.09 percent, as extrapolated from the TIPs market, after rising from a low of 0.95 percent one week ago. These are rates below even those seen at the height of the financial crisis, yet are arguably justified by the now expected pace of the economic recovery.

The problem for investors, of course, is whether the consensus economic forecast will be realized. Not only can bonds lose value as interest rates rise, because yields are currently so low the duration of bonds at various points along the yield curve has risen. In other words, bond prices can erode far more quickly in a low yield environment if rates back up. Again according to Bank of America Merrill Lynch, the duration of a 10-year bond with a coupon of 2.5 percent is 8.8 years compared to 7.8 years for a 5.0 percent coupon. This point was illustrated vividly last week. At the close on Tuesday, the yield on the 10-year Treasury note stood at 2.47 percent. After the better-than-expected Institute of Supply Management (ISM) manufacturing report on Wednesday, that yield began to rise, ending the week at 2.70 percent. The resulting decline in the principal value of the 10-year note was two full points, or almost 2.0 percent in just three days.