Four Elements of a Bond Market Bubble

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The developed world’s government bond markets are showing characteristics of a bubble. Timing the end of this rally won’t be easy — but for those watching closely, hints are emerging.

From Silicon Valley to the South Sea, bubbles can swell anywhere. Today, it’s arguably the turn of the developed world’s artificially overheated government bond markets. Government bond market valuations are at extremes, and yet the buying persists. The trend is provoking fears that bond yields are entering bubble territory. Negative rates, after all, virtually guarantee that investors will earn a negative nominal return on their bonds. However, bubbles are not defined by valuation alone. We also need to consider four elements that tend to be present in a speculative market environment.

Bond bubbles: The whole picture

1. A sound rationale

Every bubble has a rational underpinning. Intuition and logic allow investors to embrace a particular market or trend, but their excitement ultimately spirals out of control.

The dot-com bubble of the late 1990s is an example of how a seemingly transparent story can go awry. 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 supportive 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 — a phenomenon that has converted many to the “secular stagnation” thesis. The premise is that if policymakers are bound by rates close to zero, they may not be able to engineer a rate low enough to spur demand, particularly if inflation and corresponding rates of return are insufficiently low. 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.

Furthermore, we are seeing unprecedented debt loads. In theory, artificially low borrowing costs should engender explosive credit growth in the private sector. Corporations and consumers alike should be eager to borrow at low rates and invest the proceeds into something productive. But corporations, beset by overcapacity and woeful productivity, are reluctant borrowers. 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.

Finally, the paradox of thrift appears alive and well. Low interest rates are meant to encourage people to spend, stimulating the demand side of faltering economies. Yet, seeing no improvement in their earning power, many consumers are saving more, not less, to compensate for scarce investment returns. Monetary policy is largely exhausted, leaving central banks with limited scope to raise rates. It is understandable that bond markets have responded by pricing in a lack of growth and inflation over the short term. But the market has done much more than this, assuming there will be no pressure over the long term.

3. 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, distorting prices and making other market participants wary of fighting the trend even at seemingly nonsensical prices. The highly public nature of this large-scale buying creates confidence that someone will be around tomorrow to buy at an even higher price and that any selloff will be contained.

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