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Is there a bubble in bond land? That’s become the hot question of the moment with everyone from Jeremy Siegel (yes) to Randall Forsyth at Barrons (no) offering an opinion. I was even quoted in an article this week at CNN Money concerning the present state of the bond market. Goodness knows, if reporters are calling me for a fresh perspective on a particular market the story is getting quite long in the tooth so I’d say if you are long bonds, you might want to start watching your back. But since someone asked and the CNN Money reporter only managed to quote me sounding like Cassandra (is it just me or do reporters these days seem more opinionated about the topics they cover? And by the way, I’m in the “there’s no such thing as bad publicity” camp so quote me out of context, in context, in Swahili….I don’t care but keep calling Colin) here’s my two cents worth.
Some have said there can’t be a bubble in bonds because they come due someday and pay back the principal, which is true if you happen to actually own the individual bond. If you buy a ten year Treasury note at today’s puny yield and rates then spike higher, your worst case scenario is to hold the thing for ten years until it comes due. Of course, most investors don’t own individual bonds; they own a bond fund of some sort which they bought because the think if the fund has Bond - especially Government Bond - in its name it must be safe. To me the central theme of any bubble is that investors are willing to pay ever higher prices for an asset which they perceive to have little risk. And that my friends is exactly where the bond market is right now. People aren’t buying bond funds after careful analysis. They are buying them because they have been rising in price and investors think they are safe. The doom and gloom writers and analysts who quote economic statistics and Federal Reserve Governors to justify their bullish stance on bonds are wasting their breath. The marginal buyer of bonds today thinks the difference between deflation and inflation is a call to AAA.
The bullish case is well known at this point even if it is irrelevant to the average investor. The economic recovery - that average investor is right now saying, What recovery? - has been weak and appears to be getting weaker; a resumption of the recession is a real possibility. Inflation, according to the modern definition, is non existent and deflation is not only a real possibility but a Japanese lost decade or more outcome is looking more and more likely. The Bank of Japan hasn’t ended deflation and therefore the Fed won’t be able to either. The mean, uncaring deficit worry warts will prevent another Keynesian style government spending stimulus and the Fed can’t cut rates any lower than the zero bound where they are currently set. We are all doomed to a world of - at best - sub par growth and long term Treasuries are headed the way of JGBs to sub 1% rates.
I suppose all that could be true - certainly the recovery has been modest - but there are some counterarguments. Yes, the recovery is weak and I don’t think it will get much better soon without a significant change in economic policy, but isn’t a change in policy for the better at least a possibility? What effect will the election have on future policy? If the economy is on the verge of a new recession, why is oil still $75 and copper still over $3? The last two recessions pushed both of those economically sensitive commodities to much lower prices. Deflation? Really? Why is gold over $1200? What if us old timers are right and inflation has more to do with the value of the currency than the level of the CPI? What if the capital flowing into gold and other commodities is what sows the seeds of future price rises? If we don’t invest in new productive capacity how will that affect the future supply of goods and services? Could the lack of investment today mean higher prices tomorrow? What if price stability - which despite the claims of deflation is exactly what they’ve achieved - is the outcome the Bank of Japan desired and got? (Everyone talks about price deflation in Japan as if it were fact; the CPI level was 94.1417 in 1990 and is 100.325 today. You can only claim price deflation if you choose the peak of 103.308 in 1998 and even then it is modest).
What if Ben Bernanke keeps his promise to Milton Friedman and prevents deflation through the printing press? Yes, yes I know the Fed can’t create inflation because the banks won’t lend and no one wants to borrow. Really? Maybe the bond bulls haven’t noticed because they are busy counting their winnings but junk bond issuance isn’t exactly punk and junk bond funds have seen a nice inflow this year. It isn’t just government funds that the new bond investors are buying. Which brings up another little inconsistency with the return to recession theme. Why are junk and corporate bonds performing so well if we are on the verge of recession? And lastly, what if the mean old deficit worry warts are right? What if reducing the deficit by cutting government spending is exactly what the economy needs right now?
As I said above though, this discussion is mostly irrelevant to whether we have a bond bubble or not. What really matters is how these new bond investors will react to a little adversity. The people buying bond funds right now believe that they are making the conservative prudent decision and reducing the risk of their portfolio. They were burned in the dot com mania and they’ve sworn off tech stocks ever since. They were burned in the housing bubble and are upside down on their mortgage (or they’ve walked away). How will they react if they start to see losses on their “safe” bond investments? What do these investors do when bonds merely retreat to their long term uptrends? I’m not talking about a crash mind you, just a return to the long term rate of change:
20+ year Treasury ETF
Corporate Bond ETF
If these bond market ETFs merely revert to their long term trend lines, investors will be looking at losses close to 20% of their principal. I guarantee you that no one buying a bond fund today has an inkling that they are taking that kind of risk. If Ben Bernanke manages to create even a hint of inflation and the bond market reacts badly, tar and feathers may be the first commodity to see a price spike.
One thing the bond bulls have right at least for now is that the economy is weakening anew. Last week’s data was decidedly negative although an optimist like me can always find something positive. It is getting harder though and as I said above, I think it will take a change in policy to really turn things around. And I don’t mean another round of QE by the Fed. We need a change in the policies that affect real, not nominal, growth.
The manufacturing sector has led this recovery from the beginning, mostly due to the normal inventory cycle but the news is getting worse by the week. The Empire State survey at least stayed positive last week at 7.1 but all the underlying trends are now negative. New orders, unfilled orders and shipments all showed month to month deterioration. The Philly survey on the other hand didn’t even offer the balm of a positive headline. The overall index fell to -7.7. New orders, unfilled orders, shipments, employment, the workweek and inventories all fell. There seems little doubt that the national ISM will also show a significant decline. Just to be clear though; these reports are not yet consistent with a new recession. It is disconcerting to say the least that these indices are deteriorating after such a weak recovery though. Industrial Production did show surprising strength, rising 1.0% but a big part of the rise was in auto production and I can’t help but wonder if that is a seasonal adjustment issue.
The retail numbers out of Goldman and Redbook continue to show a weakening in consumer spending. The good news is that year over year changes are still positive but the rate of increase is fading. As the year progresses year over year changes will be more challenging and a pick up in activity is needed soon or we will be looking at outright declines rather than just a decreasing positive rate of change. One potential positive for consumption is the continuing boom in refinancing. Purchase applications were down slightly but refi applications are responding to lower rates, rising 17.1% last week. Housing starts were also reported higher although less than expected.
Despite the fears of deflation there was little evidence of it in the PPI report which showed wholesale inflation rising 4.1% year over year. Price increases were widespread although the core rate was quite a bit lower. Leading indicators also offered some hope for the economic bulls rising 0.1%. A lot of the components of the index seem to contradict the surveys mentioned earlier. Which report is correct is hard to determine but the LEI has a pretty solid track record.
The most worrisome report of the week was once again jobless claims which have now moved back to the 500k level. I don’t have any idea how much of this is related to Census layoffs and other one time or seasonal factors but there is no way to spin that number as positive. And I don’t expect it to get any better anytime soon. Businesses are firmly in the unusual uncertainty camp and seem determined to keep payrolls lean at least until the election results are known. I’ll have something to say about the potential for the election to change the attitude about hiring soon but for now let’s just say that me thinks they doth protest too much.
Considering the downright awfulness of the data last week, the markets performed quite admirably. The S&P 500 was down roughly 1% on the week and the NASDAQ actually managed to post a small gain. Moving outside the US, Europe had a tough week with most markets down over 1.5%. Emerging markets, as has been the case for a while, are still outperforming and that seems unlikely to change unless the developing world falls into an outright recession.
Commodities, despite rallies in a few individual markets, have not performed well this year. Just as the Treasury market is rallying based on the expectation of weak growth so the commodity indices are weak for the same reason. If that expectation is not borne out a rally in commodities could be as spectacular as the thud that would be felt in the bond market. It certainly isn’t a highly anticipated event and therefore offers the opportunity for a big move.
Sentiment measures about the economy and the stock markets are once again showing unusual concentrations of bears. The bond market may not be a bubble - who knows how the hell to define a bubble? - but I find it hard to believe that this time is different and the mass of individual investors now piling into bonds will be proven right. I can’t tell you how they will be wrong but markets tend to act to frustrate the maximum number of people. Timing the top of any market is difficult at best - alright, impossible - so I don’t know when but a steep correction in bond prices would inflict the most pain right now and so that is what I’ll worry about.
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Write a book, Joey.
Regards, Ken
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