Bond Bubble?

Depends on who you ask.

November 11, 2010

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772412_bubblesThe bond market has always been a curious place, subject to the most exquisite precision in calculating prospective risk and return – at least in the trading arena – and thus a better barometer of economic fortunes than exuberance-prone stock markets, where companies innocent of earnings can hit the top of the pops in a flash.

Is the barometer still useful? At a recent U.S. Treasuries auction, real return bonds, which factor inflation into their total return – Treasury Inflation Protected Securities – fetched a negative yield. Not a below-market yield, not a zero yield: a negative yield of 55 basis points.

“A certificate of confiscation,” is what New York Times columnist Floyd Norris calls it. “Cumulative inflation of 4.7%, or a little over 1% a year, is needed for the investor to break even. If the 2015 C.P.I. is higher, there will be a profit. If we have deflation, as some fear, the buyer does get a bit of a break. He or she will get back $100 even if the C.P.I. has fallen a lot.”

For this to be a rational bargain, price levels would have to fall so that $100 in five years’ time equals the purchasing power of today’s bond price of $105.50. Capital preservation at best. The alternative is that investors are expecting inflation to break out.

Still, no one’s betting on it with the launch of QE2 by the Federal Reserve. Quantitative easing – with the Fed buying longer-dated Treasuries to depress yields – is predicated on deflation.

Or perhaps not. Perhaps bond buyers are inflating a bubble, like the tech bubble. Said Jeremy Siegel, of Stocks for the Long Run fame, and Jeremy Schwartz in August in The Wall Street Journal of a similar bond auction:

“The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.

“Shorter-term Treasury bonds are yielding even less. The interest rate on standard non-inflation-adjusted Treasury bonds due in four years has fallen to 1%, or 100 times its payout. Inflation-adjusted bonds for the next four years have a negative real yield. This means that the purchasing power of this investment will fall, even if all coupons paid on the bond are reinvested.”

At least the auction rates for TIPs were positive then. But is that evidence of a bond bubble?

It depends. At VoxEU,  Harvard economics department chair John Campbell and two Harvard colleagues, Adi Sunderam and Luis Viceira, write: “inflation makes bonds risky at certain times, while giving them insurance, or hedge, value at others. For instance, if inflation rises unexpectedly when economic conditions deteriorate, the real value of bond payments falls unexpectedly. In this case, bond investors sustain losses when they likely need funds, and bonds are risky assets that investors should charge a risk premium for holding.

“In contrast, if inflation falls unexpectedly when economic conditions deteriorate, bonds are like insurance, providing a windfall at the time investors need it the most. Bond investors should be willing to pay for this insurance value, just as they are willing to pay for other types of insurance. In this case, the inflation risk premium should actually be negative.”

That’s the “on the one hand/on the other hand” perspective often ascribed to economists. What does the unicorn-like third hand say? “[P]olicymakers often use break-even inflation, the difference between the yields on nominal and inflation-indexed bonds (TIPS), as a proxy for market inflation expectations. However, this quantity is actually the sum of expected inflation and the inflation risk premium. Thus, if the inflation risk premium is negative, breakeven inflation understates market inflation expectations. The negative correlation between stocks and bonds today suggests that the inflation risk premium on Treasuries is negative, and it could be as low as -75 or -85 basis points. This implies that investor expectations of 10-year inflation reflected in the bond market are around 2.7%, in line with the view of professional forecasters and the inflation swap market.”

So there may be some inflation out there after all. Not very high, not high enough for President Obama don a cardigan and reflect on malaise, but still there as a painful reminder of stagflations past.

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