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January 15, 2009

Bond Bubble Trouble?
by Brady Willett

If you have not yet read about the ominous U.S. Treasury bubble (which has been around for awhile), here is recent a recap:

"Risk-free return" is the standard tag attached to the government's solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description - "return-free risk".
James Grant - December 4, 2008

"If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it"
Hussman - December 22, 2008

"What bond investors know as "breakeven inflation rates" are currently signaling a future where the U.S. CPI averages -1% for the next 10 years. Possible, but not likely.... Realistically, quantitative easing, a two-trillion-dollar expansion of the Fed's balance sheet, and the near certainty of future budget deficits approaching 6-7% of GDP should alert bond investors to once again become vigilant as was the case in the 1980s and 90s."
Bill Gross - January 2009

"The biggest investment bubble today may involve one of the safest asset classes: U.S. Treasuries."
Barron's - January 5, 2009

"The current bull market in Bonds has lasted since 1980. But only recently has the Treasury Bond market registered a record extreme in bullish consensus according to MBH Commodities' Daily Sentiment Index. Now for the first time in 28 years, 99% of traders believe the upward trend will continue. Remember when everyone thought real estate could only go up in value? At this point, the Treasury Bond market is swaggering around, certain of its own opinion that it cannot fall."
Lamont - January 5, 2009

"The trade of 2009 is to short U.S. government bonds, big time"
Marc Faber - January 6, 2009

"Treasuries are now in the hands of speculators looking to sell, not investors looking to hold. These players are analogous to the mid-decade condo-flippers who flocked to new developments for quick profits. They did not intend to occupy their properties, but rather flip them to future buyers. Once these properties came back on the market, condo prices collapsed, as developers were forced to compete for new sales with their former customers."
Schiff - January 9, 2009

"As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever."
Pritchard - January 12, 2009

While the above viewpoints intelligently explain some of the reasons why it may be foolish to rush into U.S. Treasuries, they are nonetheless worthy of a contrarian take. Here goes:

- While it may be a stupid idea to invest in something offering a 2.21% annual return over the next 10-years, this is still not comparable to chasing worthless internet IPOs in the late 1990s or skyrocketing U.S. home prices a few years ago (i.e. at least you don't go broke by parking capital in U.S. Treasuries).

- It may take a massive rush back into risk (and out of U.S. Treasuries) and/or a significant increase in inflation expectations for the U.S. 'bond bubble' to burst. Risk aversion and the threat of deflation remain the orders of the day.

- There is the possibility that U.S. fiscal and monetary stimulus measures will fail to produce a sustainable recovery; that as the U.S. follows the path of 1990s Japan calls for a bursting of the 'bond bubble' will prove dead wrong.

- Ask yourself why those recommending TIPS based upon some distant recovery theory are not ecstatically recommending higher risk instruments instead. Is it because few money managers are brave enough to bet on a return to more historically normal spreads between Treasuries and everything else? If so, is the growing crowd of pro-TIPS investor's proof that the worst (for the U.S. economy) is not nearly over?

- BCA Research recently noted that "Historically, Treasury yields sustainably rebound only once the annual growth in payrolls turns up significantly." Is it contradictory to suggest that a jobs rebound is many months or even years away while at the same time contending the U.S. Treasuries bubble is about to burst?

- The Financial Times recently noted that Kindleberger's basic definition of a bubble is "an upward price movement over an extended range that then implodes". How can the U.S. Treasury market 'implode' given that such an implosion would likely cause further devastation to the interest rate sensitive U.S. economy (which, in theory, would place downward pressure on rates)?

- Capital has been herding into supposedly 'safe' Treasuries out of fear and not greed. Given that scared investors may not carry highly delusional expectations about how their Treasury holdings will perform this may prevent panicked selling when a Treasury sell off occurs.

Suffice to say, there are reasons to suspect that U.S. Treasuries will continue to be a safe haven for capital going forward.

But worries of a great bond bust remain

You can not completely ignore the argument that China, Japan, and others will not continue to fund 'the greatest sovereign bond bubble of all time'. Rather, with president-elect Barack Obama warning last week of "trillion-dollar deficits for years to come" and the CBO forecasting a $1.2 trillion deficit before Mr. Obama unleashes his first stimulus package, there are legitimate reasons to fear that appetite for U.S. Treasuries will eventually wane. These fears were recently magnified when Germany's sale of 10-year bunds failed, and are likely to come under further scrutiny with Euro-region nations looking to borrow $1.1 trillion this year (Royal Bank of Scotland Group Plc). Like the global real estate bubble the U.S. bond bubble is potentially one that does have borders.

In short, what U.S. policy makers should hope and pray for is that when the bond bubble end game does arrive it will be because central bankers (plural) printed too much money, and not because a viable alternative to USD hegemony has emerged. Supporting the great U.S. Treasury bubble is in everyone's best interests, until it is not.

Related: The Hashimoto Factor - September 2, 2003

Brady Willett
FallStreet.com

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