Next Bubble Is Forming: U.S. Government Bonds

How the west cut its debts
The crucial issue is that during that period, the state engineered a situation where the yields on government bonds were kept slightly below the prevailing rate of inflation for many years.
Gillian Tett, FT, December 22, 2011

US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.
Niall Ferguson, FT February 10 2010

Despite a reputation for being a slow-growing alternative to stocks for the risk-averse,
bonds just passed stocks' long-term performance over the past 30 years.
CNBC, 5 Jan 2012

Gunnar Eliasson och Nils Karlsson räknar med sju procents realränta.
"Ett årligt sparande /till ett medborgarkonto/ på 23 000 kr eller drygt 1 900 kr per månad
är tillräckligt för att vid sju procents real ränta spara ihop till en miljon kronor på 20 år. ...
(Kom ihåg, att värdestegringen för aktier de senaste 25 åren varit högre än sju procent realt per år.)"
DN-Debatt 1997-11-19

For the US government, according to Bank of England data,
the price of borrowing for ten years is now at its lowest level for two centuries

- and for the British government, the implicit interest rate it has to pay to borrow is lower than it has been since the end of the Victorian era.
Robert Peston, BBC Business editor, 19 August 2011

Chart showing “long term” government bond yields since 1800
For the record, the 30-year yield is pretty low.
But even though it might feel like the world is falling apart, we’re still not as low as back in 1941,
when the world, really was falling apart.
Wall Street Journal 18 August 2011

Who’s Been Buying Treasuries?
Tim Iacono 10 June 2011

Treasury yields continue free fall
Yields on 10-year 2.36% lowest level since January 2009
CNN 12 october 2010 with nice chart

No country defaults on its domestic bonds if it retains the right to set the printing presses in motion.
US Treasuries were never risk free in the common sense understanding of the term.
John Plender, Financial Times, August 16 2011

It seems counter-intuitive that bond markets, with their traditional fear of inflation, should punish a country for not being able to debase its currency. The demise of this conventional market wisdom is one of the achievements, for want of a better word, of European Monetary Union.

In effect, southern Europe (of which Ireland is an honorary member) is going through the equivalent of an International Monetary Fund austerity programme, but without the benefit of devaluation.

The Weimar Republic would presumably have been entitled to a triple A rating since it was perfectly capable of repaying its debts, even though the hyper-inflated money used for the task would have been close to worthless.

Finance academics, with their distinction between risk, which is measurable, and uncertainty, which is not, have used language in a way that can confuse mere mortals.

And the obsession with quantifying risk by reference to standard deviations or techniques such as value at risk are not always helpful.

US Treasuries were never risk free in the common sense understanding of the term. And if the ECB is ultimately empowered to issue euro bonds that are backed by the full power of the printing press, those bonds will never be risk free in common sense terms either.

Many ask whether high-income countries are at risk of a “double dip” recession. My answer is: no,
because the first one did not end. The question is, rather, how much deeper and longer this recession or “contraction” might become.
Martin Wolf, Financial Times, 30 August 2011

Bill Gross, manager of the world’s largest bond fund for Pimco, has admitted that
it was a mistake to bet so heavily against the price of US government debt.
CNBC 30 August 2011

Mr Gross emptied his $244 billion Total Return Fund of US government-related securities earlier this year in a high-profile call that has backfired as the bond market has rallied. As of Monday, Pimco’s flagship fund ranked 501th out of 589 bond funds in its category.

“Do I wish I had more Treasurys? Yeah, that’s pretty obvious,” Mr Gross told the Financial Times last week, adding:
“I get that it was my/our mistake in thinking that the US economy can chug along at 2 percent real growth rates. It doesn’t look like it can.”

What is the “stall speed” of an economy?
Unemployment tends to rise when GDP growth falls below about 2.5-3 per cent
Gavyn Davies blog June 15, 2011

U.S. government bond yields are poised to converge with Japan’s for the first time in almost two decades,
sparking the biggest returns for investors in Treasuries since 2008
while raising concern that America may be stuck in a prolonged period of below-par economic growth.
Bill Gross, Bloomberg Aug 15, 2011

“We are beginning to resemble Japan from an interest rate policy standpoint as well as potentially an economic growth standpoint,” Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said in a telephone interview Aug. 10.

Investors are “fearful of low growth and are fleeing to high-quality sovereign paper at whatever yield.”

Credit rating agencies should never be taken too seriously, but for Standard & Poor's to put the United States on "negative outlook" is none the less something of event
Jeremy Warner, Daily Telegraph, 18 April 2011

Federal Reserve Bank of Dallas President Richard W. Fisher said he sees “extraordinary speculative activity” in the U.S.
after the central bank pumped record amounts of stimulus into the economy.
Bloomberg 23/3 2011

“There is an enormous amount of liquidity sloshing around,” the regional bank chief, who votes on monetary policy this year, said in a speech today in Berlin. “There is abundant liquidity in the machine we know as the United States economy.”

Fisher reiterated his view that no further monetary stimulus will be needed after the Fed finishes its planned $600 billion of Treasury purchases through June.

Federal Reserve policy is keeping Treasury yields too
low to provide reasonable returns for most investors
Pimco's Bill Gross told CNBC 5 Apr 2011

The yield on the benchmark 10-year Treasury note would have to rise to 4.50 to 5 percent to be at what Gross terms a "normalized" level.

Who will buy Treasuries when the Fed doesn’t?
Treasury yields are perhaps 150 basis points or 1½% too low
when viewed on a historical context and
when compared with expected nominal GDP growth of 5%.
Bill Gross, March 2011

By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch!

Pimco has dumped all of its US Treasury bond exposure in its flagship Total Return Fund.
The move makes sense given Pimco chief Bill Gross's public statements that Treasurys are over-valued.
CNBC 9/3 2011

/Pimco's/ bearish call on Treasuries will not have been made lightly.
Given the record of Mr Gross, one cannot ignore the decision.
Since the total return fund began in 1987, it has generated an average annual return of 8.42 per cent
FT 11 March 2011

Judging by the strong investor demand for new long-term Treasury debt this week and last month, few seem to share Mr Gross’s concern that inflation and the end of QE2 will send bond yields sharply higher.

"I don't know who's buying 30-year fixed debt.
I don't understand TIPS (Treasury Inflation Protected Securities)
that are projecting 30 years of benign inflation,"
Ray Dalio, founder & CIO of the hedge fund Bridgewater Associates, 3 Mar 2011
Bridgewater Associates is the world's largest hedge fund, with $8.9 billion under management.

The Congressional Budget Office recently announced that this year’s US budget deficit will be $1,500bn – a grim figure that is dominating the attention of policymakers.
Frequently overlooked, however, are our long-term structural deficits and debts; these are the biggest threat to our economic future.
Peter Peterson, FT, February 28 2011

Furthermore, policymakers tend to think of public debt problems in purely national terms, but US debt is not growing in isolation. It is part of an international debt bubble being inflated simultaneously and unsustainably by fundamental demographic changes and vast unfunded promises in virtually every advanced economy. Bubbles eventually pop – and ignoring this one could be calamitous.

With memories of last May's "Flash Crash" still fresh in investors' minds,
now comes warning of a market meltdown that could extend beyond stocks
— a possible "Splash Crash" that also would affect currencies, commodities and bonds.
The interconnectedness of high-speed trading platforms is making such an event increasingly possible, says John Bates
CNBC 3 Feb 2011

Wellcome Trust, which has amassed a £14.5 billion investment fortune,
said that it had sold its last bond in April as it positioned itself for a rise in inflation.
the country is facing its biggest inflationary threat for 20 years
The Times 16/12 2010

US Treasuries last week suffered their biggest two-day sell-off
since the collapse of Lehman Brothers in September 2008.
Daily Telegraph 11 Dec 2010

The big financial economy and markets event of the past few days has been
a sharp fall in the price of US government debt,
whose corollary is a rise in the implicit interest rate
Robert Peston 13 December 2010

There is no little debate about what all this means.
And what's particularly unhelpful is that
the competing explanations are the difference between economic heaven and hell

The fashionable explanation is that the rise in yields should be seen as good news, because it shows that investors are becoming more confident in the US economic recovery

The competing explanation may appear to be based on an almost diametrically opposite view of the prospects for the US. It is that the tax cut shows a US administration utterly incapable of getting to grips with public-sector deficit

The problem is that, even after more than two years of near-zero official rates and huge amounts of stimulus spending, economies such as the US have failed to grow as strongly as hoped.
The hangover effect of the debt-fuelled house-buying and consumption binge that started to unravel three years ago.
People are no longer able to borrow unless they have a good credit history.
In any event, many people do not want to borrow.
They are focused instead on reducing the debts they have taken on – a process called deleveraging – either by choice or because they cannot roll over debts with new loans.
FT October 31 2010

On the one hand, interest rates have plunged to historic lows, allowing companies, countries and some individuals to borrow at a cost lower than ever.
On the other hand, households and the wider economy still struggle in the wake of a credit bust.

The interplay between these two forces – the stimulating effect on economic activity of low borrowing costs and the damping effect of a debt squeeze – has severe implications for investors around the world, from individual savers to the world’s biggest insurance companies.

“Is there a bond bubble in Japan? Because if there is, it has somehow lasted for 20 years. If you don’t get legitimate economic growth, then there isn’t a bond bubble.”

Ten-year Treasury yields fell this month to their lowest levels since the dark days of January 2009.
TIPS are at similarly historical levels, lowest since the government started selling them in 1997.
A low yield means demand is high for TIPS, which offer investors additional annual returns to make up for the rate of inflation.
The gap, or breakeven, between the two yields implies what investors expect inflation to be.
WSJ 25/10 2010

Ben Bernanke declared war today - not on China, but on the possibility of deflation.
He knows that a vicious cycle of slow growth, stagnant or falling prices and high unemployment poses a much greater threat to America's way of life than China's silly exchange rate.
But like it or not, the exchange rate will be caught up in the Fed's response.
Stephanie Flanders, BBC 15 October 2010

In the 1930s, the deflationary trap was the gold standard. Britain left it first, and was vilified for doing so - but it was also the first major economy to recover.

The verdict of economic historians has been that it would have been better for the world if other countries had followed Britain sooner.

Now we have no gold standard (though the euro might be playing a similar role for the eurozone). But we do have a collection of countries, most of them Asian, who have created a modern version of it, by pegging their currencies to the dollar.

America can't abandon its own currency. But it can make things as uncomfortable as possible for those that choose to stick with it. Ben Bernanke may not have planned it that way, but that is exactly what the Fed's policy will do.

Federal Reserve Chairman Ben S. Bernanke said additional monetary stimulus may be warranted
because inflation is too low and unemployment is too high.
Blooomberg Oct 15, 2010 2:43 PM GMT+0200

Bernanke and his central bank colleagues are considering ways they can stimulate the economy as the unemployment rate holds near 10 percent and inflation falls short of their goals.

After lowering interest rates almost to zero and purchasing $1.7 trillion of securities, policy makers are discussing expanding the Fed’s balance sheet by purchasing Treasuries and strategies for raising inflation expectations, according to the minutes of the Federal Open Market Committee’s Sept. 21 meeting.

En vanlig prognos på marknaden är att Fed fram till årsskiftet kommer att spendera 500 miljarder dollar (nästan 3 300 miljarder kronor) på att trycka ned räntorna med obligationsköp och därmed få fart på tillväxten.

Dollarn föll två öre mot kronan efter Bernankes uttalande, ned till 6:53 kronor per dollar.
Det är den lägsta nivån sedan september 2008.

The deliberate attempt by the Federal Reserve to create more inflation is beginning
to have a big impact on financial markets. Yesterday the dollar came under selling, and commodity prices increased.
The dollar fell to a 15-year low (nominal that is!) against the yen, and an eight-month low against the euro
Copper reached a two year year, and gold rose further to $1387, an all time nominal high.
Eurointelligence 15/41 2010

Dålig affär av Riksbanken att sälja guldet
Därmed har den svenska centralbanken gått miste om intäkter på 594 miljoner kr
Tidigare har även finansmannen Tomas Fischer kritiserat Riksbanken för utförsäljningen av guldreserven.
DI 2009-01-07

The average rate on 15-year fixed loans fell to 3.62 percent, the lowest on records dating back to 1991.

Warren Buffett hints at bond bubble
Investors buying bonds at the prevailing high prices are 'making a mistake,'
Fortune October 5, 2010

He added that he "can't imagine" the rationale for adding bonds to your portfolio at current prices.

Chinese purchases of our bonds don’t help us — they hurt us.
The Japanese understand that. Why don’t we?
Paul Krugman NYT September 12, 2010

American policy figures have repeatedly balked at doing anything about Chinese currency manipulation, at least in part out of fear that the Chinese would stop buying our bonds.

But this fear is completely misplaced: in a world awash with excess savings, we don’t need China’s money — especially because the Federal Reserve could and should buy up any bonds the Chinese sell.

It’s true that the dollar would fall if China decided to dump some American holdings. But this would actually help the U.S. economy, making our exports more competitive. Ask the Japanese, who want China to stop buying their bonds because those purchases are driving up the yen.

Ask Not Whether Governments Will Default, but How
The sovereign debt crisis is not European: it is global. And it is not over.
Arnuad Mares at John Mauldin 20/9 2010

Faber advises investors "stay away from Treasurys as they’ve been rallying since 1981
- equivalent to a 19-year bull run," - when the 10-year bottomed out on Sep. 21, 1981.
Faber says Dec. 18, 2008 was the peak of the bond bubble with yield of 2.08% and 2.53% on 10-year and 30-year respectively.
(See 10-year chart)
August 25, 2010

Is there a government bond bubble?
Probably not, but approach low-probability risks carefully
The Economist invitation August 2010

The public are focused on countries' official debts, rather than their fiscal gaps, to gauge the need to print money.
But this emperor's new clothes continue to draw lots of attention.
Laurence Kotlikoff our guest wrote on Aug 20th 2010

Almost two years into the bond flight, about $550 billion has poured into U.S. bond mutual funds
Using inflation-adjusted figures, investors had put $499 billion at this same stage of the Internet bubble.
Colas selected December 1996, the month of Alan Greenspan’s “irrational exuberance” speech, as the estimated start of the bubble in equities.
For bonds, he uses the collapse of Bear Stearns in March 2008.
CNBC 31 Aug 2010

Yankee bonds
– dollar-denominated bonds sold by non-American companies into the US
So far this year, 773 have been issued, raising $412.9bn
– beating the $378.1bn raised up to this point last year
The attraction of the US market is lower funding costs.
Banks are the biggest issuers.
Eurointelligence 24/8 2010

We've been living in a veritable bubble bath the past 10 years what with two stock bubbles, a real estate bubble and a derivatives bubble. And now, with so much money flooding into Treasury securities and interest rates so low,
many people are wondering whether the next pop! we'll hear will be the bursting of a bond bubble.
CNN Money Magazine: Ask the Expert, 19/8 2010

But while bond prices are relatively high and interest rates inordinately low, to a large extent that simply reflects the outlook for continued sluggish economic growth and restrained inflation in the near future. Or, as the Federal Reserve Open Market Committee put it in its August 10th statement, "with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

The BIGGEST Financial Weapon of Mass Destruction
Treasury Bonds with maturities of 10 years or more
Aubie Baltin January 15, 2010

America and the World are now sitting on the world's biggest ticking financial time bomb, largely because we've pursued some of the most reckless financial policies in history. This toxic asset is U.S. Treasury Bonds… specifically Treasury Bonds with maturities of 10 years or more. They're the world's most popular investment by far… and now they're about to turn out to be the world's most dangerous!

INTEREST RATES HAVE ONLY ONE WAY TO GO, WHICH MEANS THAT LONG TERM BONDS ALSO HAVE ONLY ONE WAY TO GO AND THAT IS DOWN

The real interest rate on 5-year inflation-protected securities is now negative.
In other words, prospects for other investments are so poor that some investors prefer a safe asset that doesn’t quite keep up with inflation.
The invisible bond vigilantes continue their invisible attack: nominal 10-year bonds at 2.71%.
Paul Krugman 11 August 2010

Since the beginning of April, when optimism about the economic recovery was at its peak, 2-year bond yields have fallen by 0.63 per cent as the market has realised that the Fed would not tighten monetary policy until at least the end of 2011.
More remakarbly, the 5-year yield has dropped by 1.20 per cent, and the 10-year yield has tumbled 1.14 per cent, presumably reflecting a belief that abnormally low short rates will persist for many years to come.
The decline in bond yields has flown directly in the face of expectations that bond yields would rise because of fears about excessive government deficits, in a pattern which is disturbingly similar to what happened when Japan headed towards deflation a decade ago.
Gavyn Davies, FT 9 august 2010 with nice charts

Wednesday 10-year Treasury note yield below 3 percent
2010-07-07
up to date rates here

On Monday, the yield on 10-year government bonds was 1.1 per cent in Japan, 2.6 per cent in Germany, 3 per cent in the US and 3.3 per cent in the UK.
Based on yields on index-linked securities, real interest rates on borrowing by these governments are very low (1.2 per cent, or less, in the US, Germany and UK).
Investors are saying that they view the risk of depression and deflation as greater than that of default and inflation.
Martin Wolf, July 6 2010

Former Federal Reserve Chairman Alan Greenspan said the recent rise in Treasury yields represents a “canary in the mine” that may signal further gains in interest rates. Bloomberg March 26 2010

“I’m very much concerned about the fiscal situation,” said Greenspan, 84, who headed the central bank from 1987 to 2006. An increase in long-term interest rates “will make the housing recovery very difficult to implement and put a dampening on capital investment as well.”

Once again, cheap money is driving up asset prices
"commercial banks are causing a bubble to develop in government-bond markets"
The Economist print Jan 7th 2010

It is hard to imagine any circumstances in which the authorities will have the foresight (or the courage) to prick a bubble.
It cannot be done when the economy is weak.
And when the economy is strong, as it was in the late 1990s, central banks argue that higher asset prices are justified (back then, by the productivity improvements brought by the internet).

The gap between short-term interest rates and long-term bond yields is extraordinarily high. That allows banks, in particular, to borrow at low rates from the central banks and invest the proceeds in government debt; the same trick was used to rebuild bank profits in the early 1990s.

Russell Napier, a market historian and an analyst at CLSA, a broker, thinks that purchases by a combination of Asian central banks and developed-world commercial banks are causing a bubble to develop in government-bond markets.

How to solve the financial crisis?
Let me tell you a little secret, folks.
Play for time. A few years of nice profits will help offset the big losses from past blunders
Allan Sloan et al

The gap between yields on Treasuries and so-called TIPS due in 10 years closed above 2.25 percentage points last week, the longest stretch since August 2008.
That’s the low end of the range in the five years before Lehman Brothers collapsed,
and shows traders expect inflation, not deflation in coming months
Bloomberg Dec. 21 2009

The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.’s on terms that seem too good to be true. But that happy situation, aided by ultralow interest rates, may not last much longer. An additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.
Edmund L. Andrews New York Times 23 Nov 2009

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.

Watch out for tail risks hanging over the $14,300bn US Treasuries market
Risky to fund long-term holdings with short-term debt.
Gillian Tett, Financial Times, 19 May 2011

Those 10-year bond rates are still laughably low, meaning financing costs are cheap. But if sentiment ever swings violently, there could be a nasty wake-up call.

These days, there is a near-unanimous belief among western regulators that one way to prevent a repeat of the 2007-08 crisis is to stop banks taking crazy risks with subprime mortgage bonds or complex instruments such as collateralised debt obligations (CDOs). Instead, banks are being urged to hold a higher proportion of their assets in the form of “safe” instruments, most notably sovereign or quasi-sovereign debt. G20 regulators are holding regular meetings in Basel to draw up rules on how banks should do this, as part of a wider reform of financial regulation

That does not necessarily mean an outright default looms any time soon; indeed, default seems highly unlikely. However, it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation.
It is even easier to anticipate a sharp rise in bond yields – and a corresponding sharp fall in bond prices – particularly when central banks stop their quantitative easing programmes. Some smart hedge funds are betting on just that.

Investors should shun U.S. government bonds
former Bank of England policy maker Willem Buiter said.
Bloomberg Nov. 10 2009

“Rates will have to start rising, probably later in 2010, as inflation expectations medium and long term show up in higher long rates,” Buiter said in an interview on Bloomberg Radio today.

When asked if people should be buying Treasuries, he said: “I wouldn’t, but then I’m a leading indicator of capital losses on a range of assets.”

Ten-year Treasuries rose for a third day after a report showing German investor confidence declined.
The yield on the note, which moves inversely to prices, fell 3 basis points to 3.46 percent

As the US, UK and Japan will be trying to borrow the same buck in international markets, bond yields will rise when QE stops and there is an even modest recovery in credit demand from the private sector.
That alone is enough to prevent the development of a new credit bubble similar to those that have been economic drivers for nearly two decades.
David Roche, FT October 26 2009

All credit bubbles rely on underpriced capital being in oversupply relative to the fundamental needs of an economy. Given the huge demand for capital by increasingly insolvent governments, those conditions won’t exist.

China’s central bank warned that its counterparts in developed nations face difficult choices
as monetary easing threatens to cause “severe” inflation and exchange-rate volatility.
“Failure to manage the degree of easing may lead to concerns about mid- and long-term inflation and exchange-rate stability,”
the People’s Bank of China said in a quarterly monetary policy report, posted on its Web site today.
Bloomberg August 5 2009

Is the US (and a number of other high-income countries) on the road to fiscal Armageddon?
Are recent jumps in government bond rates proof that investors are worried about fiscal prospects?
Martin Wolf, Financial Times June 2 2009

Investors are kicking themselves for failing to spot the twin bubbles in the stock and housing markets
when the laws of economic gravity for both became spectacularly unhinged.
Now, America should be on red alert for another bubble that's destined to pop
-- outrageously overpriced government bonds, the flipside being outrageously low interest rates.
Fortune Shawn Tully, editor at large June 19, 2009

Allan Meltzer, the distinguished monetarist from Carnegie Mellon, fears that the disaster scenario is far more likely. "We'll see tremendous pressure not to raise rates from Congress, the administration, businesses and the unions because of high unemployment," he told Fortune. "As the economy picks up, the Fed will need to scale back on money-supply growth, and in a replay of the 1970s, they will not do it."

The yield on the 30-year Treasurys touched a low of 2.51 percent last year in December
but now it is back up at 3.77 percent
Marc Faber, editor and publisher of The Gloom, Boom & Doom Report, CNBC 17 Mar 2009

"Yields have already backed up pretty substantially and I tell you, I think the US government bond market is a disaster waiting to happen for the simple reason that the requirements of the government to cover its fiscal deficit will be very, very high," Faber said.

"At every market peak.. you have excess liquidity.
At the present time a very significant part of what people call excess liquidity comes actually from the American current account deficit".
That 800 billion dollars flows around the world and boosts economic activity.
Marc Faber at Michael Shedlock 1/3 2007

The most striking thing about financial markets at the start of 2009 is neither the level nor the valuation of stockmarkets.
Nor is it oil prices.
What is remarkable is the level of nominal government-bond yields.
The Economist print January 8th 2009

James Montier of Société Générale cites figures showing that ten-year Treasury yields have averaged just over 4.5% since 1798.
Today they offer just 2.5%.

“Global bond yields are sure to be much higher in five years than they are today, but this does not imply that the market currently is in a bubble,” says Martin Barnes of Bank Credit Analyst, a research group. “The economic backdrop will remain bond-friendly for at least the next six months.”

Investors must be wary of government bond 'bubble'
But is it possible to have a bubble in the most boring form of IOU?
John Plender, Financial Times, January 7 2009

With US Treasury bills yielding little or nothing and government bond yields plunging everywhere as central banks creep towards a Japanese-style zero interest rate policy (Zirp), there is talk of a government bond bubble. But is it possible to have a bubble in the most boring form of IOU?

When it comes to aerated finance the best authority is Charles Kindleberger, the economic historian who devoted much of his life to studying manias, panics and crashes. His basic definition of a bubble was "an upward price movement over an extended range that then implodes". Speculation was an essential part of a story in which investors were buying not for income and capital gain, but with a view to re-selling on a short-term basis to someone else at a higher price - a phenomenon sometimes known as the "Greater Fool Theory".

I share the view of Michael Lewitt, of Harch Capital Management, who argues that the last thing investors are thinking when they buy zero per cent Treasuries is reselling them at a profit. In most cases, they expect to resell at a loss. Rather, he argues, their priority is absolute safety and the knowledge that there will always be buyers for securities backed by the US government. Such behaviour, then, is a perfectly rational response to extreme uncertainty and the fear of deflation.

The risk, as I suggested here before Christmas, is that the upwards yield adjustment could be savage when Humpty Dumpty is put back on the wall and normal private sector financial service resumes. Given the enormous funding pressure that will exist in the early days of the Obama administration, and the potential shift of investment focus from deflation to inflation, Treasuries will at some point become an outcast asset category.

The tricky question is, "when?".

It is suddenly fashionable to suggest we are in the throes of a fresh investment bubble - this time in government bonds.
Gilts have been bid up to dizzy levels as investors buy into the notion that deflation is coming and is here to stay.
Why else buy assets yielding only 1 or 2 per cent unless you believe that Britain is heading into a Japanese-style lost decade of ultra-low interest rates and relentlessly falling prices?
David Wighton, Business Editor, The Times January 7, 2009

John Redwood, the former Welsh Secretary, who these days supplements his backbench stipend as a City money manager, joined the sceptics yesterday, saying that only the greater fool theory explained the enthusiasm for the asset class.

“You still have a massive paranoia in the marketplace and you’ve got that safety-at-any-cost mentality,” .
“People are not buying Treasury bills because they think the yields are attractive.
They are buying them because they are afraid to put money anywhere else.”
Bloomberg Dec. 15 2008

Instead of shunning the U.S., where losses on subprime mortgages in 2007 triggered a global seizure in credit markets that led to the downfall of securities firms Bear Stearns Cos. and Lehman Brothers Holdings Inc., investors can’t get enough Treasuries. Even as estimates of Obama’s stimulus package and the budget deficit rise to a record $1 trillion, demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal.

Purchases accelerated even as the yield on the benchmark two-year Treasury note tumbled to 0.76 percent last week.

The same day, the U.S. sold $30 billion of four-week bills at a zero percent rate.

Yields on two-, 10- and 30-year Treasuries last week all fell to lowest since the U.S. began regular sales of those securities.

Conventional wisdom is that in the long term, shares always outperform bonds, whose value and income tend to be destroyed by inflation. Shares are inherently more risky, but they compensate by delivering higher returns. In fact this may not even be true in the long term, as statistical analysis tends to focus on stock markets that survive economic implosions and ignores those completely wiped out by them.
Jeremy Warner, The Independent, 26 June 2008

The key question for stock markets is whether the cycle is ending in an inflationary or a deflationary nemesis.
Though much has been written and said about the possibility of a return to the stagflation of the 1970s, the bigger long-term threat to share prices would be the deflationary outcome.
Experience from the 1930s and Japan from 1990 onwards shows that deflationary influences are profoundly more destructive of equity values than inflationary ones.

Average yields on the securities rose 14 basis points yesterday to 6.32 percent, the highest since July 2002

Yields on the benchmark 10-year Treasury note rose to 4.10 percent yesterday, the highest this year. Yields on two-year Treasuries posted their biggest back-to-back increase in at least 20 years, surging 55 basis points to 2.93 percent.

Bernanke sparks a bond sell-off with new inflation warning
Bernanke triggered a jump in government bond yields in Asia early Tuesday morning by declaring in a speech that "the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."
Los Angeles Times June 9, 2008

In Japanese trading early Tuesday the yield on the two-year U.S. Treasury note rocketed to 2.93% from 2.71% at the end of U.S. trading Monday.

As market yields jump, remember, the value of older bonds drops.

Bernanke believes that the danger of a “substantial downturn” in the US economy has abated over the past month,
but that inflation risks are increasing.
FT June 10 2008

Jim Grant of Grant's Interest Rate Observer on Bloomberg
Treasuries are about as compelling a value as the kind of stuff you find in your hotel mini-bar.
Ten-year securities yielding 3.5 percent, much less than the year-over-year depreciation of the purchasing power of the dollar.
"Treasuries at these great interest rates constitute a return free risk".
March 26, 2008

Next Bubble Is Forming: U.S. Government Bonds
The Business Ledger, February 12, 2008

Bubbles are defined as markets that trade in high volumes at prices that are considerably higher than their intrinsic value.

The fundamental problems that created the current economic mess we are in today were simply a far too easy monetary and fiscal policy that encouraged leverage, consumption and risk. Borrowing as much as you could and investing it in an asset that never went down in value was the formula for success.

In studying past financial bubbles — there are some great books written on the subject), the common ingredients in the bubble recipe are a low interest rate environment that encourages extreme leverage strategies and a psychological belief by investors that the asset that is being bought and leveraged can never go down.

As this happens and the U.S. dollar falls to alarming new lows, investors will move their focus from credit concerns within the U.S. system to credit concerns about the U.S. in whole. This is what will unleash a severe bear market within the U.S. bond market as traders panic and another bubble bursts.

A repeat of the Great Depression is unlikely
Deflation is the ultimate economic calamity. This is also known as the liquidity trap.
yields may well shoot up to 6 or 7 per cent. So the “price” for avoiding deflation may be a bond market meltdown.
Wolfgang Munchau, FT February 11 2008

The Rising Risk of a Systemic Financial Meltdown:
The Twelve Steps to Financial Disaster
by Nouriel Roubini, February 11, 2008
at John Mauldin