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Revisiting the Bond Bubble Theory


During my vacation-bound plane ride I had a chance to read the latest weekly commentaries by Morgan Stanley's strategists which summarized the conclusions from the annual Morgan Stanley Macro-Vision conference. There was a lot of good stuff. Right, wrong or indifferent, the participants are pretty sharp people, and their views provide a whole lot of food for thought. The principal issues discussed were the existence - or not - of a bond bubble, and the seemingly never ending shrinkage in volatility. Below is a synthesis of their analysis on the "bond bubble" issue, with mixed-in questions and comments by yours truly. In a separate piece I'll deal with the volatility topic.

The consensus among investors participating in the conference and the analysts appears to be that there is no "bond bubble" in government bonds, but riskier assets appear overpriced. The principal reason for that conclusion is that - unlike what typically happens in the course of bubbles - government bonds are not being purchased with the expectation of being re-sold to a "greater fool" at a higher price. Secondarily, bubbles are usually followed by major bear markets, and the participants saw little chance of that happening.

In my humble opinion, an alternative environment in which a "bond bubble" could be born and prosper involves replacing the "greater fool" with the "greedier fool". The Iron Horse has been correctly calling the path of bonds - and stocks - relative to the economy for a long time. But given the disappearing yields in debt instruments - government and corporates alike - I can't help but wonder if a whole new class of bond investors - perhaps investors permanently scarred by the equity markets - are buying bonds with no regard to prices, in what amounts to a mad yield chase. After all, this type of indiscriminate value-be-damned type of buying is also alive and well in the real estate market where many homebuyers' sole focus is on the "monthly payment": it matters not that one may be paying $600/sq.ft. for a dump, because the monthly payment is only "x number of dollars", and ergo the home is a bargain. Similar behavior is spreading to the commercial real estate market, where the minimum hurdle rates of return for institutional buyers are sinking low enough for our beloved Sammy to jump over.

Another thought, given that insurance and pension funds are the most avid buyers of bonds and commercial real estate, is whether the mania in the latter is not just a logically correlated result of the former (the classic conventional view), but rather whether we are witnessing a parallel buying binge in two "yield-rich" (relative to current alternatives) asset classes.

Is the yield chase an unintended and unconventional consequence of excess liquidity much as excess liquidity, according to Morgan Stanley's J. Fels, is the trigger for the disconnect between falling Treasury yields and shrinking spreads for lower quality assets? Is excess liquidity the silver bullet that truly strengthens the financial position of corporations, or does it constitute a papering over - literally - of the problems left behind by the bursting of the internet bubble? And, lastly, within our ever more asset-centric economy discussed by Prof. Succo, is the yield chase / excess liquidity tactic actually back-firing by attracting capital into relatively passive investments and starving other potentially more productive asset classes of much needed liquidity?

The answers to these questions are well beyond my reach. But the growing dichotomies of rising commodity prices and low reported inflation, strong reported growth and a flattening yield curve, a falling currency and falling interest rates, etc., etc., etc., make me wonder whether the same types of forces that pushed the misallocation of trillions of dollars of capital during the internet bubble are once again at work in different areas, specifically the debt and liquidity sensitive markets.

For example, in his review of the Asia/Pacific economies, Andy Xie notes that Japanese institutional investors seemingly bizarre desire for U.S. Treasuries despite the plunge of the dollar vs. the yen, can be easily explained by the carry trade du-jour consisting of selling JGB's and purchasing U.S. Treasuries, to capture a 300bps spread. Can anyone reasonably ignore the consequences of our twin deficits simply because the carry-traders (a/k/a speculators on steroids) can be counted on to finance the medical costs of child birth, our last social security check, and everything else in between? Is this carry trade - which according to Xie remains profitable with JPY/U.S.$ as low as .80 10 years from now - one of the main reasons why we have not seen the Japanese freak-out over their currency losses?

Broadly speaking, a bubble derives its painful connotation more from the damage it spreads when it pops than from the conditions it creates to ultimately create havoc. That perhaps is why many subscribe to the view that a bubble can only be identified in hindsight. Given my propensity for being "often wrong, but never in doubt" I'll join Mr. Fels in his concluding remarks:

"However you look at it there is no denying the impact of a record low fed funds rate in recent years on asset prices: To keep the economy going after the equity bubble burst in 2000, the Fed pumped a bubble in fixed-income assets. Liquidity is the key. . . So the party in risky assets could rave on for a while, until the music stops."
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