Treasury Market Bubble?

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One of the big issues that investors have been debating recently is whether we have a bubble in the Treasury market.  I have reviewed a lot of articles and I want to describe some of the arguments on both sides.

Quick Primer for Beginners (There Are Many New MBA Students Who Are Joining the Email List…)

When you buy a bond, you will receive coupon payments (usually twice per year) and you will get $1,000 back at maturity (assuming there is no default).  When investors buy bonds, prices increase.  When prices increase, that means yields are lower.  In other words, a bond promises to make fixed coupon payments (lets say $20 each six months).  If you only pay $900 for this (and it’s a ten-year bond), your yield (return) is going to be 5.30%.  But, if you pay $1,100, your yield (return) is going to be 2.84%.  In other words, higher bond prices mean lower yields.


My Description of a Bubble

I’m going to define a bubble as a tremendous run-up in the price of a particular asset class or type of security whereby prices move far away from intrinsic value (what something is really worth).  During this run-up, there is widespread optimism that prices can only go higher. 


Some people would also include the idea that a bubble must end with a crash – prices returning to intrinsic value and inflicting significant pain on investors.


Examples of recent bubbles include tech stocks in the late 1990s and the real estate bubble (in many parts of this country) that ended in 2007.


The Arguments That This is a Bubble

1. Treasury yields are reaching historic lows, especially long maturities.


2. The 10-year Treasury yielded 2.6% Wednesday, down from 4% just four months ago.


3. Treasury yields have decreased 31% since the beginning of the year.


4. Treasury returns have significantly beaten the stock market since April.


5. The ten-year yield dropped below the dividend yield of the Dow Jones Industrial Average for the first time since 1962.  (This actually happened before 2008, but then dividends were slashed.)


6. There has been $559 billion inflow into bond mutual funds and $233 outflow from equity funds from January 2008 to June 2010.  Treasury bonds returned 13% over that span while stocks lost 21%.


7. There is little evidence of deflation (which would justify really low rates).


8. We’re eventually going to have to print dollars (because of our unfunded liabilities) and that will be inflationary (so prices must not be reflecting intrinsic value).


9. China is reducing their holdings and PIMCO recently lowered their holdings…yet prices are increasing.


10. Tobias M. Levkovich (US equity strategist at Citi) said that he found a “startling” correlation between equity returns in the period from 1990 to 2005 and Treasury bonds since 2000.  In other words, this will end like the tech bubble.


11. Levkovich also pointed out that the money flow into bond funds is similar to the money flow into equity funds in the 1990s. Investors put $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000, according to data compiled by Bloomberg and the Washington-based Investment Company Institute.


12. Investors are buying Treasuries, but rates can really only go higher from here.


13. The chase for yield always ends badly.


14. Investors are simply buying Treasuries because they are fearful and if this fear subsides, bond prices will fall.


15. In “The Great American Bond Bubble” by Jeremy Siegel (Wharton professor) and Jeremy Schwartz (director of research at WisdomTree), they argue that the four year US Treasury is yielding 1%, and they analogize this to buying tech stocks with a P/E ratio of 100.  (They also make the same analogy to TIPS with a 1% yield.)  These are TERRIBLE analogies.  Bond investors will get their face value ($1000) back.  Even if we have inflation, the purchaser of a four year UST will not get crushed.  While this is a terrible argument that Siegel and Shwartz made (in my opinion), I still want to include it in the arguments being made.


The Arguments That This is NOT a Bubble

1. Low yields are not simply a UST phenomenon.  Bond yields have dropped around the world.  The 10-year UST hit 2.53%, the German 10-year bund fell to a record low 2.27%, the U.K. gilt hit 2.98%.  In Japan, the 10-year yield is .94%.


2. David Rosenberg pointed out that Federal Reserve policy has a 90% correlation with the direction of bond yields.  The Fed is not going to increase rates for a long time.


3. The Fed is committed to rebuilding the banking system.  They’re not going to let yields rise.


4. The average spread between the fed-funds rate and the 30-year bond has historically been 200 basis points.  With the long bond at 3.60%, the 30-year yield could still fall a long way (meaning long bond prices could continue to increase).


5. If we have deflation, the real returns will look large.


6. The Treasury market is simply forecasting a slow economy.


7. We are seeing a slowing economy and a government that is determined to prop up a weak recovery.  This has caused rates to fall.


8. We see little sign of economic strength, inflation or the Fed raising rates.


9. The inventory adjustment (which had a huge impact on GDP in recent quarters) is mostly done.  In addition, the stimulus is largely done.  There is little reason to expect high GDP growth.


10. We have 9.5% unemployment, capacity utilization under 75%, low home prices and stocks that are in a trading range.  Treasuries may be a wise choice for investors.


11. We are seeing risk aversion – and this is rational.  There is great uncertainty about the economy, taxes, spending and politics.


12. We’re seeing a shift from speculation to saving and it’s reflected in the purchase of Treasuries.  Older investors are really trying to save (without taking risk) and this is impacting the price of Treasuries.


13. Banks aren’t lending money, so they’re buying Treasuries.  This demand is increasing prices.


14. It’s hard to have a bubble in bonds because we know what the cash flows will be.  It’s different than the speculative nature of tech stocks or Las Vegas housing.


15. Selling is not going to lead to more selling (if bond prices start to fall).  We’re unlikely to have the type of crash that we saw with tech stocks.  Again, we have an idea of what the cash flows will be.  You know that the government is going to give you your $1000 back at maturity.  While you risk not keeping up with inflation, you don’t risk seeing your investment go to zero.


Conclusion

The point of this article is simply to identify the arguments on both sides.  I think that many of the arguments (but not all) on both sides are compelling!  I think that the economy is horrible and we’re unlikely to see any inflation for a while.  As a result, I think that it will only feel like a bubble to investors who buy really long-term Treasuries with the thought that they will hold them until maturity.

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