Bond Bubble?
Eddy Elfenbein at Crossing Wall Street has put forth the concept of a “bond bubble” over at his blog. I support the concept in part, but I need to modify it. Let’s call it a Treasury Bond Bubble, because other classes of intermediate term debt have significant yield spreads over Treasuries because of the current economic volatility.
Should 2-year Treasury notes yield less than CPI inflation? No, and CPI inflation is not going down. Scarcity of food and fuel are normal conditions in our growing world. We can only extract so much out of the planet in the short run. Why lend to the government at a loss? Better to invest in a money market fund, or perhaps, the stock of a business that is inflation-sensitive, or TIPS.
Can 2-year yields go lower? You bet they can. The Fed is flooding the short end of the yield curve with liquidity for now, until inflaton pressures become intolerable. In the present political environment, the Fed is incented to loosen, even in the face of rising inflation. Remember my “pain model” for the Fed. They move in the direction that avoids the most political pain. People are screaming over a weak economy now, and no one complains about inflation. Thus they loosen. How much at the end of January? Uh, that is up for grabs. My view of the Fed is that they want to drag their feet, because they see inflation rising, so even if Fed funds futures indicate a 75 basis point cut, my current view indicates 50 as more likely, again, with language in the statement that indicates even-handed risks.
One final note: the concept of a bond bubble sounds a little like the Austrian school of economics. The central bank pushes interest rates below the natural rate of interest (i.e., the one that would exist in an free market equilibrium), in order to stimulate the economy. Bonds would be worth more than their long-term intrinsic value in such a scenario. That’s true today, with one modification, because of the credit stress, only the highest quality borrowers get those rates.
January 20th, 20088:56 am at
What if one believes we are in the early stages of a deflationary depression? Just curious what your scenario would be for this. Would seem money would continue to flow into treasuries out of other assets. Commodities wwould get crushed – just curious what your thoughts are. Thanks
January 20th, 20089:47 am at
I think David’s post highlights two major issues. First, I admit to being an Austrian-leaning type.
I think there is a great confusion amongst many government officials and market participants between prices and inflation. Even during the hard money 19th century, there were price booms/busts and cycles. This is econ 101 whether one is Austrian or Keynsian.
The value of the US dollar was relatively stable for about 100 years even with all of the boom/bust cycles. Ag and energy prices are a perfect example of this and Kondratieff’s cycle work on prices holds up regardless of hard or fiat money. Why is this? Because the long term balance between supply and demand for hard to secure resources can get WAY out of line on the upside and downside. As Jim Rogers says, there hasn’t been a major oil field discovery in over 30 years! Global inventories for many ag commodities are falling fast.
These developments create cyclical and even secular price trends – but that is not inflation. That is free market economics. Inflation is the destruction of purchasing power on a permanent and not cyclical basis. Since 1913, the Fed has been THE force, along with deficit spending, behind massive inflation.
As for the “bond bubble”, it seems to me that the term bubble is overused. I often wonder when I hear Bill Gross talk about the “real” rate based on “core inflation”, whether he is just talking his book or really that dumb.
If one believes that the CPI is a reasonable measure of a standard of living, then the current one is fraud. It is more of a “standard of existance” index rather than standard of living. That is the root nature of substitution adjustments.
As John Williams at Shadow Statistics calculates, the pre-Boskin commission CPI is running in the high single digits. I think anyone who is honest about their personal inflation rate would concur that is reality. So let’s assume that policy should be determined based on consumer prices (I don’t agree), then the real 10 year yield is probably around a negative 3-5%. I disagree with David in so much as even a 300-500 bps spread would simply result in a real yield of -2 to 0.
As much as I think the stock market is in trouble over the long term, I’d rather own stocks than most bonds at these price for a 10 year horizon. Of course, owning short duration debt in strong currencies (like the Yen) and some gold is probably better than either!
January 20th, 20086:06 pm at
Here, here on the bubble talk! Until speculation is so rampant that “investors” are buying zero coupon bonds above par, let’s reserve the b-word for when it really applies.
January 21st, 200811:49 am at
LOL, I love Allan’s definition of a bubble, buying zeros above par!
Just a heads-up for all of my American friends reading David’s blog, today the bubble is in panic. Right now the TSX (Canada’s main stock index) is down 5%, about 600 points, and markets globally are sinking too. If this translates to the US open tomorrow, the DJIA would be down 600 also.
Get ready for the panic, unless central banks globally act to try to forestall it. Given their fairly ineffective efforts so far, it might be akin to King Canute commanding the tide…
Some fantastic bargains are beginning to show up, but it’s hard to fight the crowd all trying to squeeze through the door on the way out.
Steve
January 21st, 200811:45 pm at
David; I hope you have time to post tomorrow on real Money as I have to beleiev tomorrow will be no fun. Thanks as always
January 22nd, 200812:19 am at
I second Paul. It’s hard to believe that the Fed won’t intervene more aggressively now, though.