Next Bubble Is Forming: U.S. Government Bonds

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

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