So much for the bond bubble

Big talk, small action.

John Rekenthaler 4 October, 2018 | 5:00PM

In 2010, the 10-year U.S. Treasury bond yield fell from 3.8% on New Year's Day to 2.5% at summer's end, thereby raising the question: Are bond prices in a bubble? Fortune wondered in April of that year. A few months later, three Harvard economists tackled the topic. By then, the debate had become familiar. Were bond yields at 50-year lows for good reason, or had the movement been speculative?

Today, we know the answer. That was no bubble. In the ensuing eight years, the 10-year Treasury yield has ranged between 1.5% and 3.0%, with its midpoint hovering just above 2010's low. With annual inflation averaging 1.8%, the real return on the Treasury has been only slightly positive--but positive it has been, nonetheless. Bubbles don't lead to portfolio gains.

(Nor do bubbles last eight years. To my surprise, the first page of a "bond bubble" Google search was stuffed with 2018 articles, including an allegation from former Federal Reserve Chairman Alan Greenspan. Nope. The statute of limitations on the bubble argument has expired. If bonds do collapse from here, it will not be because their 2010 valuations were unreasonable. It will instead be because today's investors, collectively, have incorrectly forecast future inflation rates.)

Broadly speaking, the investment public got it right. By and large, it didn't fuss about bond bubbles. The possibility that bonds might have been severely overbought, and therefore facing future losses, made for lively discussions on investment-enthusiast websites, but it bypassed most everyday investors. Their cash was building up; safe instruments yielded nothing; stocks caused bad memories; and something needed to be done. Bonds it was.

The experts' errors

Instead, the concern about the bond bubble came from investment professionals, most of whom were wrong. Clearly, those who predicted that bonds would crash were incorrect. (Once again, if bonds crash tomorrow, their losses won't vindicate the 2010 bears.) Less clearly, many of the bond market's bulls were also mistaken. They accurately believed that bonds would fare well in the near term as the global economy fought through its debt overhang, but they thought that inflation would resume over the next three to five years. For that, we are still waiting.

The experts were let down by history, as the signals that they had long followed no longer proved helpful.

For decades, researchers had closely followed changes in U.S. money supply, believing that relatively rapid increases would lead to a temporarily stronger economy, accompanied by increased inflation. Then would come higher short-term interest rates as the Federal Reserve sought to reduce inflation, economic stuttering and reduced money growth (or even shrinkage). The Fed would respond by cutting interest rates, which would stimulate money growth, and the process would repeat. The guideline for bond fund managers!

Even before the 2008 financial crash, money-supply statistics had become unreliable. (A few years ago, I asked a University of Chicago economist why The Wall Street Journal had buried its money-supply reports on Page C17, when it once placed them on the front page. His response: "That stuff doesn't work any more.") After the crash, predictions about the effects of very low short-term interest rates, and the Federal Reserve's program of "quantitative easing," proved equally unhelpful. The expected inflation did not arrive.

Thus, the "dumb money" that purchased bonds in 2010 outfoxed the smart money that forecast a bubble. (To be sure, bond buyers would have been better off yet--much better off--had they purchased equities instead, but that is a different argument.) Implicitly, the consensus wagered that abnormally low bond yields would be compensated by quiescent inflation, while the credentialed critics expected otherwise. The consensus won its bet.

Not always right

This particular lesson I will not generalize. To be sure, the wisdom of the crowd deserves respect. As this column has previously pointed out, most "bubbles" turn out otherwise. Many researchers believe that they have spotted obvious investment mispricings, but few accomplish the task. The major financial markets rarely make self-evident mistakes.

However, rarely is not the same as never. In the late 1980s, investment experts lined up to explain why Japanese stock prices were irrational--that no matter how one did the math, the country's giant and mostly mature corporations could not generate the growth rates that were necessary to justify its stock market's valuations. Japanese investors ignored the controversy. For that, they were severely punished, as almost 30 years later the Japanese stock market languishes 30% below its 1989 peak.

(On a side note, that linked chart of the Nikkei Index illustrates one of the difficulties of charting long-term data. Because the difference between the starting and ending values is so huge, even large fluctuations can get lost in the shuffle. At first glance, today's Nikkei value looks to have just about reached its previous highs, but that view is deceptive. The Nikkei is currently at 24,000, as opposed to 34,000 at its highest.)

Similarly, the '90s tech-stock boom was widely decried by the elite, even as it was widely supported by the rank and file. Many naysayers cried "Wolf!" too early. Greenspan, for example, perceived "irrational exuberance" in 1996; stock prices promptly rose and would never approach those levels again. Others, however, were very much on target with their predictions that technology stocks would be hard-hit early in the New Millennium.

In summary, although it seemed otherwise to many at that time, bonds were priced sensibly after the 2008 financial crash. Their yields were not to everybody's liking--certainly not to mine!--but finding an investment to be unattractive is different than expecting its price to decline. The first is easy to justify; the second is not.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is Vice President of Research for Morningstar.