Gary Norden is the Owner/Director of Organic Financial Group, a financial markets advisory firm. In his 25 year career he has traded and managed trading desks for some of the world’s largest investment banks. Gary is the author of ‘An End to the Bull’. For more information please visit www.organicfinancialgroup.com .
Read an article about bonds and you will almost certainly find the word "bubble" contained in it. Calling a top to the 'bond bubble' has become a favourite pastime of many commentators and analysts and as always, this type of prediction receives huge exposure in the media. In a way this is why the predictions are made - to generate exposure for a sell-side individual.
For me the last straw in this 'bond bubble' frenzy was an email from a well-respected source where the author was calling a top to US Bonds due to a 'scary' looking chart. The chart was showing a head and shoulders pattern and with US 10 year yields at the time around 2.1%, we were told that yields were set to explode. When analysts start using unreliable chart patterns to make their case I start to think we have reached the depths of analysis.
So I want to explore a more balanced assessment of the bond markets.
Let's get some facts straight to start with:
- Global bond yields are at very low levels and in some cases record low yields.
- Global bonds have been in strong demand for some years now supported in some cases by Central Bank buying.
- Most bond markets are pricing in a continuation of this environment.
So yes, bond prices are high and have risen for many years - but does this constitute a bubble?
If we go back to Bonds 101 we know that bond prices will reflect interest rate expectations, economic growth expectations, inflation expectations and to some degree currency expectations too.
It is a fact that across most of the developed world we have seen very low inflation figures and if anything in recent times inflation rates have declined further. There remains a risk of deflation and we are yet to see any real signs of inflation that would spook bondholders.
Similarly interest rates in most countries in the developed world have been in decline in line with the low inflation and stubbornly slow GDP growth.
So economic conditions, interest rate policy and inflation expectations support low bond yields. This to me suggests that whatever happens to bonds going forward, we are currently not in a bubble. A bubble is said to be when prices are irrationally high - bond prices are high but far from irrational.
A good measure of bubbles is to look at how the worst companies or in this case credit are faring. If we look at Greek bonds for example we do not see a bubble we see a market that has been pricing in heightened risk. Similarly the corporate credit of Australian iron ore minor Fortescue Metals Group (FMG) is yielding in excess of 10% in an environment where other un-rated bonds are yielding around 6-7%. Again this does not look like a bubble to me - during bubbles even the trashiest names rise with the market. Good quality credit does currently offer very low yield, historically low but then interest rates and inflation are historically low too.
There are countries such as the US where interest rates can seemingly only go higher and we are currently waiting for the Fed to hike, likely some time this year. I suppose this is why we are getting so many predictions of bond Armageddon; with a hike likely, one of the reasons for low bond yields has been taken away- namely falling interest rates.
I agree that a Fed hike has the potential to drive yields higher particularly as the longer end of the US curve does not appear to be pricing this in (at the moment). Of course this could change and the reflexive nature of markets means that if US 10 year yields are say 2.5% when the Fed hikes the potential for bond Armageddon will be reduced. However, it cannot be argued that any Fed hike would be a 'black swan' type event because it is something that all traders are aware of.
However, US growth and wage growth remains relatively subdued for this part of the cycle. Further a key difference between the current situation and previous years is the strong US dollar. If inflation remains low then you can make a strong case for foreigners to buy US bonds even at yields of 2% and pick up a substantial currency gain.
Liquidity concerns are often cited and I agree that if everyone headed for the exits at the same time there would be trouble. However, liquidity risk is something that traders should be factoring in to every trade - it is not exceptional to the current bond market.
Having traded in the Japanese markets for many years I have heard the 'bond bubble' crash predictions for its government bonds (the JGBs) for many years. While there are some differences between US and Japanese bond markets perhaps most notably that the former is dominated by foreign owners while the latter is mainly owned by domestic accounts, I am always cautious when I hear the term 'bond bubble'. In fact some of the current harbingers of doom readily admit they have wrongly predicted the JGB crash for years too. With Japan we have seen the same arguments that just because prices are high (yields low) it must be a bubble. Of course as deflation took hold in Japan and the Yen strengthened, we know that JGBs remained a good investment particularly for domestic accounts. Note also that the liquidity risk arguments have been prevalent throughout the strength of JGBs.
So yes, bond prices are high but they have thus far been supported by the economic and monetary conditions. That does not in my opinion make this a bubble - it is not irrational.
Yes, bond traders are currently pricing in a continued low yield environment and all traders need to factor that in to their decision making. What could happen if the market is wrong? That is a legitimate question, but one we ask with any trade.
Yes, the Fed hike might provide a trigger for higher yields but if the US dollar continues to rise, foreign buyers might still be attracted. Equally though, any higher than expected inflation print, could cause a rethink of yields. This does not make yields a bubble - it is actually how all markets work. Participants are pricing in what environment they expect going forward and if they are shown to be wrong there is the potential for a large move.
If inflation remains weak though then yields may not rise too much. Remembering that the anticipated Fed hikes are just getting rates away from emergency levels but a Fed Funds Rate of even 1.5% would still be very low by historical standards.
So I'm not arguing that yields are too high or too low because as with all decision making in markets, we are faced with a more complex situation. Today with US 10 year yields at 1.8% the situation and market positioning is different from even just a few weeks ago when yields were 2.1%. If inflation rises or if GDP growth accelerates then current bond yields would be too low - but they are 'ifs'. If we get deflation and a continued strong US dollar then US 10 year yields of 1.8% look high.
What I can say though is that simple analysis and references to bubbles cannot suffice and we should be wary of the bubble babblers.
Predictions of doom, bubbles, crash and more might make for good media but we need to remember that people are making important investment decisions on this analysis.-Let's try to keep things more grounded and avoid the hyperbole and if I hear the term 'bond bubble' one more time...