Everybody knows that a bubble cannot last forever. Eventually all bubbles burst. That is certainly the case within the financial industry as well, and now experts are seeing even more signs of an impending explosion of the “bond Bubble.” A financial bubble occurs when the market price of a security or a group of securities increases well beyond the point where the long-term benefits of ownership fail to compensate the investor for the costs — market price, trading costs, liquidity, etc. — and risks of ownership.
If you remember in the first presidential debate, now President-Elect Donald Trump said,
“Now, look, we have the worst revival of an economy since the Great Depression. And believe me: We’re in a bubble right now. And the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down. We are in a big, fat, ugly bubble. And we better be awfully careful. And we have a Fed that’s doing political things. The Fed is keeping the interest rates at this level. And believe me: The day Obama goes off, and he leaves, when they raise interest rates, you’re going to see some very bad things happen, because the Fed is not doing their job.”
According to a story by Columbia Management Investment Advisers, there are four elements to a bond market bubble. The world’s government bond markets are showing signs of a bubble and hints are emerging.
1. A sound rationale
There is a sound rationale for very bubble. The dot-com bubble of the late 1990s is an example of how a seemingly transparent story can go bad. Then, just as now, there was considerable confidence that technology was capable of revolutionizing nearly every aspect of society and that many companies would be transformational and generate super-normal profits. But investors became indiscriminate, failing to distinguish the value-adding firms from the imposters. The underlying rationale never wavered, but it gave investors the excuse to drastically overpay for companies. Interest rates are low today for a very simple reason: Growth and inflation are low and are likely to remain so. Global GDP and global inflation have a long history of correlating strongly with interest rates. The current cycle is no different and supports investor intuition that rates should be depressed. So far, so good, but it’s not the same as saying yields should be this low.
2. It’s different this time
Investors believe today’s good bond market conditions will never end. Is it different this time? Yes. Policy rates are currently at or close to the zero bound in many markets. But this has done nothing to elevate inflation and growth expectations. And if recessionary pressures build in the coming quarters, central bankers will have seen an entire cycle pass without ever being able to meaningfully hike rates. Plus, we are seeing unprecedented debt loads, and consumers ended the last cycle with so much debt that they seem unwilling or unable to re-lever at any price. Policymakers have no choice but to keep debt servicing costs as affordable as possible.
A visible hand instills confidence
The so-called visible hand, a buying force that is both powerful and visible to all, invokes a high level of investor confidence that the trend is long-lasting. In today’s fixed-income bubble, central banks are that visible hand, and it shows up daily in the form of quantitative easing.
Central banks are purchasing billions of government bonds in their bid to stimulate global economies, artificially propelling prices higher and yields lower. The Bank of Japan, for example, is purchasing more than $700 billion of Japanese government bonds every year. Central bankers are the bull in the china shop.
4. An invisible hand fosters complacency
Finally, there is an invisible hand often working to propel prices higher. China’s capital outflows have put immense pressure on global real rates and the so-called term premium — the yield advantage gained by extending maturity along the yield curve. A savings glut, slowing business investment and worries over potential devaluation in the yuan have all provided the impetus to move money offshore. Pension funds and insurance companies require assured income to meet the promises made to savers and policyholders. Many have liabilities exceeding the duration and maturity of their assets. Lower yields worsen this mismatch, creating an acute need for many of these players to add more duration as yields move lower. Other financial institutions, such as banks, are being forced through regulation to add more safe assets.
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