We've been talking a lot about the bond bubble recently.
So has everyone else.
The big question is – is the recent surge in yields just a blip, or has the bubble already burst?
It's not controversial to say bonds are in a bubble
Citi just put out an analysis note on bubbles. They say it takes four ingredients to make a bubble.
One, you need a good story. Two, you need lots of money flying about looking for a home (I'm paraphrasing all this, but this is the upshot). Three, you need an imbalance between supply and demand. And four, you need career risk – fund managers being forced to chase these assets higher for fear of missing out.
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So take the tech bubble. Good story: the internet would change the world. Lots of money: interest rates were low and got lower after the crisis sparked by the collapse of hedge fund Long-Term Capital Management. Supply/demand imbalance: investors couldn't hoover up tech stocks fast enough – at least until the bubble popped. And finally, you had asset managers feeling forced to chase things higher, even although most of them knew it had to end in tears eventually.
What's bubbly today? Bonds, especially in Europe, look expensive of course. The convincing story in this case is the 'secular stagnation' story. This is the idea that we live in a 'new normal' world, where growth will stay low, as will inflation, and therefore interest rates. It's been right so far – no wonder so many people believe in it.
As for the other factors – there's easy monetary policy; and on the supply and demand side, you have central banks scooping up bonds as fast as their governments issue them. And of course, many money managers are still in the business of chasing overvalued assets even higher.
In short, it's not particularly controversial to argue that bond prices look overvalued.
The question is: what brings that to an end?
Is this really the turning point for the global bond market?
As John Authers points out in the FT, the recent spike in German bund yields (when yields rise, bond prices fall), has got everyone very excited about a potential turning point in the bond markets.
And maybe it is. After all, the bonds gave up "five months of gains in a matter of days". But as Authers also adds, they are still incredibly expensive, with yields remaining near rock-bottom levels.
This isn't the first 'tipping point' we've seen either. The 'taper tantrum' in May 2013 rattled equity and bond markets – this was when then-chief of the US Federal Reserve, Ben Bernanke, talked about reducing money printing in the US.
The markets survived that brush with fate. Will this one be any different?
As Citi notes, bubbles tend to be ended by central bank interest rate hikes. Or at least, the end of a bubble coincides with rising interest rates. However, rate rises aren't likely until we see inflation rising. At the moment, that's not what's happening.
Moreover, the world's central banks are likely to remain 'behind the curve'. That means that 'real' – after inflation – interest rates will probably stay negative.
In the case of German bunds in particular, yields may have hit a low – driven there by fears of deflation and a general rush to buy ahead of the European Central Bank (ECB). But with the ECB likely to be doing quantitative easing (QE) for a long time to come, it's hard to see how they can correct much further.
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The pin that pricks the bubble is out there
There is a problem with this sort of thinking, however. Contrary to what many people seem to believe, bubbles are in fact fairly easy to spot. The precise pin that pops them is not.
But assuming that everything will be fine, just because you can't see the exact mechanism by which sub-prime debt (for example) derails the global financial system, is not an optimum strategy.
It's true that rising rates often accompany bursting bubbles. But that was back in the days before QE. You could argue that in relative terms both the US and UK are running tighter monetary policy because they are no longer doing QE.
And as Authers points out, bonds could feasibly fall into a self-perpetuating sell-off. People have been playing the market with borrowed money, to boost their returns. If that goes into reverse – investors lose hefty amounts and have to sell up to avoid 'margin calls' (being asked for more money to cover their exposure) – we could see "cascading losses".
Or maybe the Fed will simply have trouble working out what to do with interest rates. The best outcome for the status quo, in some ways, would be for the US to have fallen back into recession, as some expect.
Bond market turbulence could hit pensions
But with unemployment still falling, there's equally a good chance that the economy could surprise everyone on the upside. If that happens, pressure will grow on the Fed to raise interest rates faster than markets anticipate. That could scupper the "bonds are a sure thing" mentality in the markets.
And of course, there's the financial Schrodinger's Cat that is Greece. It just repaid a bill to the International Monetary Fund (IMF) by – in effect – using a cheap loan from the IMF itself. If that's not a sign that a country is out of cash, I don't know what is. The longer this goes on without resolution, the greater the chance that it ends with someone chucking their toys out of the pram and the threat of broader disruption.
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In short, there are plenty of pins out there. Assuming that the central bank printing press can blunt them all is a big assumption to make.
Our regular contributor, MacroStrategy's James Ferguson, wrote a great piece about the bond bubble in a recent issue of MoneyWeek magazine. If you've not already a subscriber, get your first four issues free here.