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Thinking About Bond Bubbles….

A little over four years ago it was very popular to declare that the US Treasury Bond market was a “bubble”.  A number of high profile people made that prediction including Jeremy Seigel, Nassim Taleb and many others.  Even Warren Buffett was hinting at a bubble.  There were also many of us who said, quite loudly, that this was erroneous thinking.  From memory, Brad Delong, Paul Krugman and myself were among the more vocal here.   T-bonds have generated a 50%+ return since then and while some people will likely double down on their “bubble” call I don’t think today’s environment looks all that much more bubbly than the non-bubble of 2010.  I don’t have nearly the necessary time nor the space to hash this out completely, but here’s my general thinking on the matter.

First, I define a “bubble” as:

“A bubble is an environment in which the market price of an asset has deviated from its underlying fundamentals to the point that its current market price has become unstable relative to the asset’s ability to deliver the expected result.”

So, in order to believe that the T-bond market is unable to generate the type of returns that investors presently expect you basically have to believe that the US government will become unable to make the payments on its debt.  Or, you likely believe the real rate of return will be far less than what investors expect.  Ie, inflation will soar in the coming years.

There are a lot of moving parts here, but the first part of this discussion should be relatively easy to resolve.  As I’ve explained many times in the past, the US government is virtually guaranteed to make the necessary payments on its debt.   That is, the US government is a contingent currency issuer with a Central Bank that can always finance its debt and a Treasury that is likely to always find ways to make the necessary payments.  There’s some element of political risk there, but a default is highly unlikely given that it would be nothing more than a self-inflicted decapitation.   The USA is not Greece where the country cannot print its own currency and is at a very real solvency risk if the ECB or Germany were to impose such an outcome on Greece.  The same goes for many of the peripheral countries in Europe and so I would be much more inclined to call some peripheral countries “bubbly” than a country like the USA.  So the issue of solvency risk is largely misguided to begin with.

The inflation story is much trickier.  If you believe interest rates are going to surge due to high inflation then you believe the economy is on the verge of a boom (interest rates would surge in a booming economic environment).  Or you believe the 70’s are about to come and we’re entering an era of stagflation.  I don’t have the time to cover this thoroughly, but as I’ve outlined in the past, I think the boom outcome is unlikely given the private sector debt overhang and the weak global economy (Europe in particular thanks to an unworkable monetary union).  This environment, in my opinion, also does not resemble the 1970’s.  The key reasons are a lack of labor class negotiating power, the differing oil price dynamics and the fact that there is no credit boom (yes, there was a credit boom in the 70s).

All of this, in my opinion, means that there is likely no bubble in US T-bonds.  That doesn’t necessarily mean they’re as attractive today as they were a year ago or 4 years ago, but the implication of a crashing market (which is what the “bubble” fear mongering implies) is a vastly overstated risk.  This also doesn’t mean there are no bubbles in bonds or higher risk bond markets (pockets of European debt and high yield do worry me at present), but we should be very clear about US government bonds.