Bubble Bubble Bonds in Trouble
Market prices reflect probability US turning into Japan.
September 2, 2010
One indicator of a bubble is the amount of money flowing into the investment. And there are firms that make a living tracking fund flows. Of late, in the U.S., funds have been flowing out of equities and into bonds.
Is that a bubble? Not necessarily says hardcore value investor James Montier. “The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.” For him, that’s a sterile debate. The real question is whether bonds offer good value.
Some think they do. Money manager Cullen Roche at Pragmatic Capitalism argues: ”When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad.”
Montier doesn’t think so. “I’ve always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.”
Real yields are at 1% and forecast inflation is at 2.5%. To that Montier adds an inflation risk premium of 25 bps to 50bps.
“Using these inputs a ‘fair value’ under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a ‘fair price’. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds – introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this ‘parameter’ uncertainty it would be reasonable to say that ‘fair value’ for 10 year bonds is somewhere in the range of 4-5%.”
But fair value is not what investors are pricing in, he notes.
“The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is the correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy and hold proposition.”
Either bond investors are underestimating inflation, or Japanese deflation looms. For Montier, “in essence, the market is implying a 70% probability that the US turns Japanese.”
Not happy news for U.S. policymakers.