Treasury yields sink even as rate rise looms (Financial Times, 24 June)

US 10-year Treasury yields looked set to close below 4 per cent this week even as investors prepared for the Federal Reserve to raise short-term interest rates again next week.


Typically, as short-term interest rates rise in response to inflation pressures, longer-dated bond yields rise to price in greater uncertainty.

The divergence this time has been described as a “conundrum” and observers have been at pains to construct coherent theories for why it has happened.

What If It’s a Bond Bubble and Condo Conundrum? (Bloomberg, 22 June)

“When technology stocks get to levels we don’t understand, we call it a bubble,” [president of Bianco Research Jim] Bianco said. “When real estate gets to levels we don’t understand, we call it a bubble. But when bond prices get to levels we don’t understand, we call it a conundrum.”

We all know – now that it’s burst – about the dotcom stock bubble. We’ve discussed in previous diaries the strong likelihood that there is a real estate bubble. I’ve also tried to mention in other diaries the bubbly phenomenons in the financial markets, and I am glad to have seen the two articles quoted above, who are asking the right question: do we have a bond bubble?

“If you ask people why interest rates rose from 1946 to 1981, you’ll get a one-word answer: inflation,” Bianco said. “Ask people why interest rates fell from 1981 to 2003, and you’ll also get a one-word answer: disinflation.”

Not so with the question du jour of why long-term interest rates have defied the Federal Reserve(which has raised the funds rate to 3 percent from 1 percent), the economy (which has grown at an average rate of 4.3 percent the last two years), and record budget and current-account deficits.

“Ask people why long-term rates are currently so low and you’ll get a lot of reasons,” Bianco says. “This is throw-it-on- the-wall-and-see-what-sticks analysis.”


The Fed offered its own explanation for the conundrum: a glut of global savings. This view gained wide acceptance because investors regard the Fed as omniscient when it’s merely omnipotent.

Other candidates to explain the conundrum include a slowdown in global growth, part real, part forecast; Asian central bank buying; pension fund buying in order to better match long-term liabilities with long-term assets; the aging population, with its demand for fixed-income assets; and a predominance of short positions on the part of bond investors, who have been forced to cover as the conundrum failed to resolve itself in their favor.

The fact that there are so many possibilities, offered up at convenient times and with little conviction, suggests everyone is shooting in the dark.

But that fails to answer the initial question. Why are we searching for something to explain low long-term rates and stating definitively that housing is a bubble? For all the talk of a housing bubble, why so little discussion of whether bond prices represent a bubble?

The fact is, both the housing bubble and the bond “conundrum” are caused by the same thing: the era of cheap money unleashed by ‘Bubbles’ Greenspan’s policies of incredibly low interest rates. Cheap money has made it possible to inflate the prices of assets, whether housing or financial, by making the debt to pay for them more affordable. Now this era is slowly coming to an end with the steady rise in the Fed rates (which still remain pretty low by historical standards), but the money slushing around is still there and has had time to give birth to more (with asset price increases giving everybody more “wealth” to leverage once again on another deal).

In addition to the reasons listed above, i have the following suggestions as for why long term bond prices have remained so high (and yields/interest rates correspondingly low):

  • it is a bubble, and people are getting sick and tired of losing money by betting against it, so they are finally joining the party: “if it’s not going to go down, let’s go up along” (a number of investors in recent years have lost money by betting that interest rates could only go up and bond prices down);
  • it is a bubble, and people are protecting themselves. US Treasuries are the safest haven around. They don’t pay much, but al least they won’t default. To get better returns in today’s frothy markets, you need to take incredible risks, and more and more people are aware of it, and deciding to give it up for safety. As a fond manager, it’s really hard to take decisions that will make it certain that you fund’s return will be lower than the others (who are investing in bubbly assets), because that’s how you are assessed. So the fact that many of them are deciding to do it nevertheless would speak volumes about the perceived riskiness of other investments. Simply put, the risk to lose a lot of money is becoming bigger than the risk of being a few points behind the others by “not joining the fun”.
From the Bloomberg article
Without individual investors, who have never been a force in the Treasury market, reporters lack the anecdotal ammo to elevate the conundrum to bubble status. (“Soccer Mom Bets Life Savings on Bonds Before Employment Report.”)

Probably the single best explanation for why bonds are a conundrum, not a bubble, is that Greenspan said they are. The Fed chief framed the debate by assigning a quotable, pithy, Latin- sounding noun — conundrum — to the persistence of low long-term rates. What if he had said, “We at the Federal Reserve continue to be stupefied by low long-term rates in the face of our efforts to normalize short-term rates?” Maybe we wouldn’t be talking conundrum today.

So Greenspan has created the bubble, made everybody happy by inflating away the value of their assets, gained God-like credibility in the process, which he uses to deny that what he’s done is just one big runaway bubble, and most people are simply happy to go along. After all, it’s worked wonders until now, hasn’t it?

Remember, <u>all he cares about is that it does not crash before the 2008 elections.</u&gt

Now, just a few words for individual investors:

  • if you have bonds in your portfolio, don’t worry, their interest rate will not change. Simply, when such bonds are traded, their price reflects not their face value, but the value that reflects the interest rate then prevalent in the market. If you keep them, you will get your capital back, and the initial interest rate of the paper;

  • if you are invested in bond funds, there is a bigger risk that these will lose their value – if the bubble bursts, which may happen, soon, not so soon, or not at all if I’m totally deluded. But again, US Treasuries are at least safe instruments, whereas bonds from corporates or other issuers may end up being less safe. So check what you have, how it is managed, and decide where you want to have your money invested. As usual, caveat emptor.
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