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Last updated: January 29, 2013 8:57 pm
The ominous upward creep in US Treasury bond yields in recent days leads to the inevitable question. Could this be the beginning of the end of the great bond market bubble? The big jump in US durable goods orders revealed on Monday certainly reinforced the impression that the Federal Reserve may retreat from its unconventional monetary measures sooner than hitherto expected.
The case for a 10-year Treasury bond on a yield of just under 2 per cent when the equity market offers a tempting momentum trade also looks tenuous to those of a short-term disposition. For those with long-term pension liabilities it simply looks threadbare. Yet a clear-cut answer to the bubble question is not to be had.
Bond market bubbles are curious phenomena. They are not primarily about irrational exuberance because they are driven by both greed and fear. Yields in the index linked market remain largely negative at present, which feels distinctly bubble-like.
Yet they have been driven down by the perfectly rational fear that extreme monetary measures could lead to inflation and that inflation could be part of the solution to the developed world’s overhang of public sector debt.
Perhaps this should not really be called a bubble because the protection offered by index linked is invaluable if you fear the worst, even if the security offers a negative real return.
In the fixed interest sector something irrational is undoubtedly going on, but it is less a matter of exuberance than desperation in the pursuit of yield. In higher yielding parts of the market prices are out of touch with default risk.
Despite the oft-heard central bankers’ refrain that bubbles are impossible to identify until after they have been pricked, historical comparisons leave little doubt that this is a bubble – one, moreover, to which central banks have contributed their fair share of hot air. It is rare indeed for investors to pay a multiple of more than 50 times for the income stream on a 10-year Treasury bond.
The impossibility, as with all bubbles, lies in predicting when investors will run out of puff. What we do know is that when the fixed interest prick happens, it will be potentially very nasty because the excessive exposure of banks to government debt markets creates serious systemic risk. And when the central banks stop buying it is a safe bet that few private sector investors will be prepared to step into their shoes at anything like today’s yield levels.
Since the start of the year there has been genuine exuberance in the equity market. This is understandable because there is a conveniently optimistic narrative to hand. Apart from the liquidity impact from the central banks, there is a growing feeling that the US economy could at last be approaching the sunlit uplands, with the housing market turning round, fiscal problems becoming more manageable and shale gas transforming the energy market.
In Europe Mario Draghi, virtually canonised by capitalists at Davos, is perceived to have put the eurozone back on track. China appears to have avoided a dramatic slowdown.
That feels like the kind of story that can give backing to a bubble. Certainly, any setback in the equity market seems likely to be temporary. The risk is that when quantitative easing is withdrawn all asset markets, not just bonds, will take a big tumble. Alternatively, if it continues for too long, asset price inflation could be the precursor of rising inflation in the markets for goods and services.
Brendan Brown, head of economic research at Mitsubishi UFJ Securities International, draws an interesting parallel with the great asset inflation of the mid-1930s which culminated in the Roosevelt recession of 1937-38. Between 1934 and 1936 the Federal Reserve pursued a policy of quantitative expansion whereby the monetary base exploded in line with gold inflows after the dollar’s devaluation from 1933 onwards. US equity and commodity prices soared in 1936, helping to pull the US economy into a strong recovery.
Yet prices lost touch with geopolitical reality as Hitler rearmed and the Japanese military ran amok in China. Europe was gripped by monetary turmoil. And the Fed was signalling from late 1936 that it would put an end to abnormal monetary ease by raising bank reserve requirements.
Today China, still resentful of that Japanese aggression in the 1930s, is sabre-rattling over the Senkaku, or Diaoyu, islands. Iran threatens to become a nuclear power and much of the Middle East is in turmoil. The eurozone is once again in the grip of recession, while Japan remains becalmed in mild deflation.
The developed world’s financial system remains fragile. All of that should put a brake on further appreciation in equities. I am not convinced that it will.
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