The Bond Bubble

The financial press has given credence to those who insist that, because interest rates have fallen rapidly since April, we are in some kind of a bond bubble.  Investors, they say, should shy away from fixed income because, surely, they will be hurt when interest rates rise.  Technically, this statement is correct – the crucial part of the statement is “when interest rates rise”.  If they rise in the near term, then the advice is accurate.  But if they aren’t going to rise for a long time, investors are missing out on valuable and stable returns.  To ascertain the time horizon, consider the following facts:

• U.S. economic growth has recently turned anemic – from 5.0% in the 4^th quarter of ’09, to 3.7% in this year’s 1st quarter, to 1.6% in the 2^nd quarter.  Even with the most massive fiscal and monetary stimulus in history, growth appears to be decelerating.  GDP is still lower than it was at the 4^th quarter ’07 peak (33 months ago).  This has never happened in post-WWII history.  Interest rates cannot rise under these conditions;

• With unemployment at 9.6% and at 16.7% when underemployment is counted, and with the economy struggling to create jobs, where will the demand come from that causes businesses to demand funds to expand and cause banks to ration credit by raising rates?  In fact, bank loans have continued to contract since the economic malaise began, and businesses are sitting on the largest hoard of cash in history.  This environment isn’t conducive to rising rates;

• The American consumer has 130% debt/income ratio, up from a 100% ratio in 2000.  History shows (Rinehart & Rogoff, This Time is Different, Eight Centuries of Financial Folly) that after credit bubbles burst, the consumer debt/income ratio reverts back to its pre-bubble level.  So, we still have a long long way to go.  I suspect that we will eventually get there through a combination of consumer debt repayment and default.   Once again, this is not an environment in which interest rates can rise;

• Mortgage rates have fallen from over 5% to 4.3%, and still there is little demand.  There is a 12 month inventory of unsold homes at current sales rates, and this doesn’t count the shadow inventory not on the market or the continuing new supply surely to come from a continuing record level of foreclosures.  FNMA is once again offering loans with a $0 down payment!  If they can’t sell these homes with these rates and terms, how can they sell them if rates are rising?;

• The Fed is talking about a second round of Quantitative Easing (governmentspeak for money printing). Increasing money supply implies a lower, not higher, level of interest rates.  The Fed has also told us that it isn’t going to raise rates for “an extended period”;

• The “new normal” as PIMCO calls it, is a change in attitudes by the populous toward debt levels and a desire for higher savings and greater frugality.  Such attitude change also occurred in the Great Depression and had a lasting impact on the generation of that time.  Ditto here.  Higher savings increases the supply of lendable funds implying lower, not higher interest rates;

• Baby boomers, approaching retirement age, have experienced two equity market meltdowns in the last 10 years.  They want more stability in their portfolios and perceive they can achieve that objective with fixed income instruments.  Their portfolios are currently under weighted in bonds.  So, the continuing demand for bonds appears to be strong.

There are two examples in modern history of very long periods of artificially low interest rates.  The first is 1942-1951 when the Fed “pegged” the long-term Treasury rate at 2.5%.  Today, the rate on the 30 year Treasury bond is 3.70%; so there may still be a significant downward move in rates, even from current levels.  The second example is the Japanese experience of the past two decades where interest rates have been similar to what we see today in the U.S.

While the supply of money appears plentiful, should we worry about the demand for our debt declining, thus causing rates to rise to place that debt?  The demand from the Chinese and the rest of the world, we are told by the bond bears, can dry up rapidly and cause our interest rates to rise.  Looking at the data, that has already begun to happen, as China reduced its holding of U.S. Treasury debt in both May and June, yet the 10 year Treasury yield peaked in April and has steadily declined.  With trillions of dollars in cash, no cost to borrow, no appetite for lending, no capital base required to hold Treasury debt, and the promise of low rates for an “extended period” by the Fed, U.S. banks are purchasing all of the debt the Treasury can issue.

Eventually, interest rates will rise.  The question is “when”.  Here are some indicators to watch:

• Job creation of 200,000 per month and a falling unemployment rate;
• GDP growth consistently above 3.5%;
• The debt/income ratio of the American consumer approaching 100%;
• An upsurge in home sales causing a rise in mortgage rates toward 5%;
• The Fed eliminating “extended period” from its press releases and FOMC minutes.

None of these appear imminent.  If there is a bond bubble, it is in an early state, and, from the observations above, it appears that it will be quite a while before upward rate pressures appear.

Robert Barone, Ph.D.

September 8, 2010