Financial bubbles are always created under similar conditions: a frenzied demand for a security or commodity ostensibly in short supply driven by a belief that unique circumstances – “a new paradigm” -- justify the sharp escalation in value.
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The final ingredient in this recipe is panic among investment fund managers that they’re missing out on the gravy train and that their clients will dismiss them if they don’t get on board quick.
The current debate over whether bonds have entered into bubble territory mirrors situations investors have seen twice in the past two decades when bubbles inflated and burst, leaving a wide path of devastation in their wake.
In the late 1990s investors scrambled for the first generation of internet stocks with little concern for fundamentals such as earnings or something even closely resembling a profitable business model. The economy, according to dotcom cheerleaders at the time, had entered “a new paradigm” in which technology would fix everything.
When the dotcom bubble burst in 2000 and 2001, it wiped out thousands of jobs and billions of dollars from the retirement accounts of misguided investors who had placed all of their eggs in one basket.
A few years later much of Wall Street bet the house – pun very much intended – that “a new paradigm” guaranteed that real estate prices would continue to climb at unprecedented levels for the foreseeable future. When that didn’t happen a financial crisis ensued that temporarily crippled the global economy.
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The Bubble May Already Be Bursting
Now, a combination of low interest rates and cheap liquidity created by global central banks, combined with growing demand for a limited supply of government debt, has led to concerns that bonds are -- depending on one’s perspective -- already in or rapidly approaching bubble territory.
Indeed, by some measurements the bubble may have already started to burst. The iShares Barclays 20+ year Treasury Bond Fund (TLT) has fallen almost $20 since topping out in January 2015. The decline was only about 14%, but it has wiped out all of the gains of 2015. Thirty-year U.S. Treasury bonds have fallen roughly $13, while the 10-year U.S. Treasury note is off about $4. Numerous bonds have given intermediate sell signals. They have also caught a number of market participants off guard.
On a yield basis, the 10-year Treasury note has gone from a low of 1.68% back in January to 2.28% today. The 30-year Treasury bond has gone from 2.25% to 3.07% today in the same period. The rise in yields has seen a rush out of the long end of the yield curve into the short end of the yield curve, where U.S. Treasury rates are almost zero for maturities under three months and are still only 0.60% out to two years.
Last month, former U.S. Treasury Secretary Henry Paulson told Bloomberg that it’s not a question of whether there are bubbles but how big they are and whether the financial system is prepared to deal with them. “Until we get back to a world where interest rates are determined by real economic forces and reflect economic reality, there are going to be asset bubbles...There’s going to be volatility and clearly there are bubbles, so the question is, are they manageable and how big they are,” he said.
In a recent report, Citibank laid out a strong case that bonds have achieved bubble status.
“Maturing bull markets usually produce bubbles,” Citi analyst Robert Buckland said in the report. "These are based around a convincing idea (Secular Stagnation?), fueled by cheap liquidity and destroy many contrarian investors.”
Retirees Most at Risk If Bubble Bursts
Secular stagnation is the current “new paradigm.” According to contemporary conventional wisdom, secular stagnation will ensure that growth and inflation will remain low well into the future, keeping pressure on interest rates as well. That theory has held up for over six years now, more than long enough for investors to be convinced of its veracity.
The Citi report continued, “When we look at the current situation, a demand/supply imbalance is evident again. Since the financial crisis, security issuance has fallen and central bank buying risen. The overall effect is that the two cancel out and net security issuance is zero. Given rising demand for financial assets, it is unsurprising that prices are rising and potential bubbles inflating. Once we ex out central bank purchases, there just isn't any new paper to go round."
Most alarmingly, Citi sees a bubble in European bonds, while U.S. stock markets are in danger of reaching bubble status, but are not quite there yet. “European fixed income markets seem most euphoric,” Citi said. “Valuations here are around two standard deviations expensive relative to history.”
The question is, who will be most negatively impacted when the bubble bursts?
The risks are especially great for retirees living on fixed incomes, experts say. Many retirees gravitate toward bonds and bond funds once they are no longer taking home a steady paycheck because bonds are far less risky than stocks and because they generate a small but steady income if held onto for the duration of their maturity.