REVISITING THE BOND BUBBLE

About a year ago we were undergoing a pretty similar economic scare to the one we are currently experiencing.  The Euro crisis was heating up, the US economy was showing mild signs of slowing and yields on the 10 year were rapidly on the decline.  This all sparked a furious debate about the supposed “bond bubble”.  The bond bubble calls were near universal.  We saw it from Nassim Taleb, Jeremy Siegel, Fortune Magazine, Smart Money magazine and a whole slew of other investors who were predicting the inevitable surge in yields as bond vigilantes attacked the US government bond market and took yields higher in protest.

I was one of a handful of people who said this was total nonsense (the other vocal critics were Brad Delong and Paul Krumgan – kudos to them).*  My reasoning was rather simple.  I described how interest rates in the USA are a function of Fed policy.  I further described that a “bubble” implies the potential of catastrophic losses.  Given the weakness in the economy and zero interest rate policy, I said the description of a bubble was way off the mark.  I’ve repeated this ad infinitum over the last year at nearly every point along the way as yields would spike and the bond bubblers would break out their victory cigars (none more infamous now than the Bill Gross QE2 call – wrong twice in a row).  Most importantly though, I said that most of these bubble fears were based on a defunct and misguided understanding of our monetary system.

Most recently, I described why Treasuries combined with gold were just about the perfect hedge for this crisis – a counterintuitive idea that didn’t sit well with investors before the trade generated an outrageous amount of alpha for those who understood it and executed it.  On a longer time horizon, an investor who purchased the long bond ETF (TLT 20 year plus ETF)) at the peak yield last year has generated an incredible 10% total return over that period.  Of course, yields are at record lows today with the 10 year sinking to 2%.

Some might think this is a case of me being “arrogant”.  I seem to get that a lot these days when I point out something I predicted accurately (yes, it happens on occasion!).  But the point is not to toot my own horn.  The point is to show that being right matters.  And more importantly, being right validates an underlying process.  I base much of my thinking on an understanding of the monetary system rather than neoclassical myths that are taught in most of our schools these days.  Unfortunately, being right doesn’t matter enough on Wall Street.  And we see this time and time again as “respected” analysts trot out flawed analysis based on a misunderstanding of the underlying system.  It’s even more pervasive at the political level.  And it’s highly destructive.

My hope is that good analysis will be vindicated by reality.  And ultimately, I hope that being right helps shed light on the actual workings of our monetary system.  Better understanding leads to better decision making which leads to better results.  This isn’t only applicable to portfolio management.  It is applicable to all things in life.  Ultimately, we’re all in this game for one reason.  We hope to further our personal prosperity so we can provide better lives for ourselves and our loved ones.  There’s not much more to it than that.  When all the screaming in the trading pit stops, the numbers stop flashing and the bells stop sounding we all go home and pick up our kids, crawl into bed with someone we love or saddle up to the bar next to a friend (maybe your best friend is Mr. Daniels – who knows?).  But the point is that we can’t get to a level of better prosperity if we continue to trot out myths and misunderstandings.   It’s quite simple – a lack of understanding leads to faulty decision making which leads to poor results.  Welcome to the US economy.  Don’t enjoy your stay.

* Edited thanks to reader Dimm.  Sorry for the oversight Dr. Krugman!