Wednesday, August 18, 2010

The Unpoppable Bond Bubble?

Colin Barr of Fortune/CNN reports on the unpoppable bond bubble:
Bond prices have been soaring since U.S. job growth hit a wall in June. Yields on government bonds have dropped to levels last seen in March 2009, when stocks were still reeling from the post-Lehman Brothers bust. The 10-year Treasury yielded 2.6% Wednesday, down from 4% just four months ago.

With hopes of a V-shaped recovery fading, income-generating bonds look like a smart play. But Siegel writes in an op-ed published Wednesday in the Wall Street Journal that "those who are now crowding into bonds and bond funds are courting disaster."

Siegel, author of "Stocks for the Long Run," notes that if interest rates merely rise back to levels seen in April, recent buyers of 10-year Treasury bonds will face capital losses more than three times the size of the interest payments they stand to receive in a year.

He likens the recent rush to bonds to the tech stock bubble that burst a decade ago, comparing government bonds trading with a 1% yield to Internet stocks that traded around 2000 at 100 times earnings. All it would take to bust the bond market, Siegel suggests, is a sign that current pessimism over the economic outlook is overdone.

Siegel's right about the bond market walking a tightrope. But even those who agree with Siegel concede that there is no sign that a gust of economic recovery winds that might knock bond prices into free fall -- which means the current, apparently unsustainable, bond rally could continue for longer than anyone might like to say.

Stuart Schweitzer, global markets strategist for JPMorgan Asset Management, says the bond market is currently discounting a long period of subdued growth. That may not change till policymakers led by Fed chief Ben Bernanke act to eliminate the risk that falling prices will stall the U.S. deleveraging cycle, he said.

"The odds will grow with time that policymakers will shift from fighting inflation to fighting unemployment," said Schweitzer.

But after spending more than $1 trillion on bond purchases to keep money flowing through the economy in 2009 and early this year, the Fed is moving cautiously. It said last week that it would buy more Treasurys with the proceeds of maturing mortgage bonds to keep the money supply from contracting, but falling inflation expectations (see chart, above) suggest it needs to do much more.

And with questions about taxes and spending cuts unlikely to be settled till after the midterm congressional elections in November, another period of uncertainty likely lies ahead. In the meantime, bond yields could go still lower, absent an unlikely Fed intervention or a surprisingly strong jobs report next month.

Meanwhile, the plunge of bond yields isn't just a U.S. phenomenon. Yields on Japanese government bonds have dropped from already low levels to a minuscule 1% on 10-year paper. The Japanese experience, where 10-year yields haven't risen far above 2% since the late 1990s, shows a bond market rout is no sure thing.

"Policymakers will find a way," says Schweitzer. Perhaps. But it will take time – and lots of it.

Back in January 2009, I asked whether there is a bubble in bonds and concluded:

If deflation does develop, what seems like a bubble in bonds today, will be nothing compared to what will happen when investors throw in the towel and just buy bonds for the long-run.

The threat of deflation, quantitative easing, and liability-driven investments by global pensions is what's driving bond prices higher. Moreover, some pensions are leveraging up on bonds to meet their actuarial returns. And banks are borrowing at zero on the short end, purchasing bonds to make the easy spread and trading in higher yielding risk assets all around the world.

All these factors are driving bond prices higher, and while it may look like a bubble -- and likely is a bubble -- it's unlikely to pop anytime soon. Inflation expectations are the key gauge for bond yields, and according to Douglas Porter, deputy chief economist with BMO Nesbitt Burns Inc, the drop in yields on Treasuries suggests the US economy is in for five to 10 years of slow growth:

“An old rule of thumb is that real yields are a proxy for expected real growth,” Mr. Porter said in a report to clients. A proxy for the real yield (interest rates minus the inflation rate) is the 10-Year Treasury Inflation Index note. The 10-year TIPS or U.S. Treasury Inflation-Protected bonds are barely yielding 1 per cent, while the five-year TIP yields are now flirting with zero.

“The sustained drop in yields across the Treasury curve [for various bond durations] in recent months has been driven as much by a sharp drop in real yields as a descent in inflation expectations,” he said. The inflation rate implied by the data over the next 10 years is 1.9 per cent, which is a long way from deflation.

“The market seems to be saying that real growth will remain quite weak for years, but outright deflation is not a high probability … yet,” he said.

While bond prices have soared driving yields down, the stock market has languished. The record low level of interest rates should arguably also lead to an expansion in the price-to-earnings multiples on stocks, but that has not happened. Interest rates are low and earnings have been robust, but given the miserable 10-year performance on the S&P 500, investors continue to steer clear of stocks.

Stocks have languished and investors have been piling into bonds and corporate bonds, fearing deflation. But as foreigners continue to purchase US Treasuries, and the yield curve flattens, global banks and global pensions will have to start looking elsewhere as they search for yield.

It is my contention that the liquidity tsunami will continue to drive all risk assets higher. To be sure, we don't have the crazy leverage of the past built in the financial system, but you'll see more than a few bubbles forming in the next few years and they're all linked to the biggest bubble of all, the US bond bubble.

Martin Roberge, Portfolio Strategist and Quantitative Analyst at Dundee Securities, wrote a comment, Gold: The time Has Come for a Bubble:

History shows that gold and gold equities outperform under three scenarios; heightened economic/financial risk, outright inflation and/or deflation. The latter risk is spotted by our gold reflation gauge, which jumped into positive territory lately. As such, we have become more comfortable with golds’ fundamentals and are raising the gold group to an overweight stance. The next push up, in our view, could mark the beginning of a much-awaited price bubble in gold land.

Over the near term, gold and gold equities are driven by what we call “economic oxygen”, that is, expectations of economic reflation forces. This is what our gold reflation gauge (Exhibit 1, 3rd panel) tries to capture by monitoring movement in four variables, namely, US M2, the US$ index, bond yields and gasoline prices. Contrary to the gold price advance seen in H1/10, the recovery that started in August has a stronger fundamental backdrop, with all four drivers listed above going in the right direction for the bullion (Exhibit 2). The net result is a sharp jump of our reflation gauge into positive territory, meaning that investors are expecting/demanding monetary/fiscal rescue to alleviate the deflation scares that have emerged lately.

As quants, we play probabilities and odds now favour investing in gold and unloved large-cap golds. Indeed, tables in Exhibit 1 show that when our gold reflation gauge is above zero, the annualized monthly return for the bullion is 16.1% (with the probability of rising at 71%) and for gold equities vs. the market, it is 32.8% (with the probability of outperforming the market at 65%).These statistics suggest that conditions are in place for gold and gold equities to push into a higher price range over the next 3 to 6 months.

Importantly, a higher price range for large-cap gold equities would imply a break above mutli-year price resistances. Indeed, Exhibit 3 shows that on the next push up, the index of world gold equities would break above its 2009 and 1987 peaks relative to the world equity index. Interestingly, Exhibit 4 shows that relative forward earnings of the largest gold stocks (G, ABX and NEM) have already surpassed their 2009 peak. Remember that relative price and earnings strength are two powerful quant attributes.

Bottom line: We are raising the gold group from a neutral to an overweight stance. Lagging large-cap gold stocks are poised to break multi-year price resistances over the next 3 to 6 months. The next push up, in our view, could mark the beginning of a much-awaited price bubble in gold land.
In my last comment, I mentioned that several prominent hedge funds are placing big bets on gold. The reasoning is that in an uncertain world, gold offers refuge against the ravages of both inflation and deflation (especially physical gold).

Finally, let me end this comment by going over another big bubble which I have referred to in the past, the bubble in alternative investments fueled by global pensions funds and their insatiable appetite for "absolute returns".

Bloomberg reports that hedge fund icon Stanley Druckenmiller is quitting the business after three decades, telling investors he’d been worn down by the stress of trying to maintain one of the best trading records in the industry while managing an “enormous amount of capital.”

Don Steinbrugge, chairman of Agecroft Partners, talked about Stanley Druckenmiller's decision to shut his firm and end his 30-year career with Carol Massar and Matt Miller on Bloomberg Television's "Street Smart." Please click here and listen carefully to Mr. Steinbrugge's comments on pensions' assets flowing into hedge funds and how they are diluting returns and the skill set of many hedge funds (I also embedded the interview below).

Will other hedge fund titans follow Mr. Druckenmiller into retirement? I am sure they will but maybe they're waiting to play one last bubble before the Mother of all bubbles pops.

No comments:

Post a Comment