Which pin will burst the bond bubble?


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.

Bond market turbulence could hit pensions

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.

Alternative investments
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Which pin will burst the bond bubble?

Fine wine is one of the best-performing asset classes of the last 20 years, and prices are still going up as demand from China hits new highs - particularly at the top end of the red wine market.

However, there are no guarantees that this trend will continue, and the experts recommend that nobody goes anywhere near wine as an investment unless they can afford to lose a substantial proportion of their money - or if they would be happy drinking their losses.

They highlight that in 2008 and 2011, the market saw some serious slips - in fact in 2011 it fell 30% - so it’s important to be alive to the risks

We’re used to the idea of the value of cars falling over time, but desirable classic cars can actually gain in value. The most desirable handful of cars have seen their value double in the past four years, while even the kinds of classics that most people can afford are increasing in value by anything up to 20% a year.

However, as with all of these alternative investments, this isn’t guaranteed to continue in the future, so you should never invest what you cannot afford to lose.

Buyers also need to bear in mind that unless they are keeping the car in mint condition in a garage, they need to pay to keep it on the road - which can easily cost £1,000 a year - more if something big goes wrong.

Some owners think of this as the price they pay for the hobby of owning the car - quite aside from the investment - but if you consider the two together, it’s easy to see how even if the car itself increases in value, you’ll end up paying out more than you gain.

According to Knight Frank, antique furniture has had the worst run of all of the luxury investments. Prices fell 8% last year, and are down 22% in five years and 24% in ten.

This is partly because older antique furniture is falling out of fashion. As a result, more fashionable early and mid 20th century pieces have done better, and are up 29% in ten years.

Passing fashions make this a particularly volatile investment, so in this case more than any other, investors should buy things because they want to see them in their home - with the handy side-effect of a potential increase in value if they buy something iconic and unusual.

And while they should buy the best they can afford, they need to ensure they do not spend more than they can lose - or choose to keep in the lounge if the bottom falls out of the market.

Investing in rare coins is one of the most buoyant parts of the alternative market at the moment - with values up 10% in a year, 90% over five years, and 221% over ten years. However, this is definitely an area for experts, because unless you know what you are doing it’s easy to be taken in by counterfeits, doctored coins, and dealers who encourage you to spend more than the coin is worth.

Most people tend to start collecting coins as a hobby, investing to own something they love, hoping they will see some gains, but willing to take a loss on their collection if they ever had to sell. With this sort of approach, the big gains are likely to be well beyond your reach, as they are focused on the top end of the market. However, it should protect you from unaffordable losses if the value of your collection drops.


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