The Great Debate© is presented by Econintersect.com to expand our understanding of various topics of interest. John Lounsbury has written about analysis that indicates the bull market in bonds will have a broad top. He presents a summary of his views here. Ted Kavadas, a guest author, has written views that disagree with Lounsbury’s conclusions and he summarizes them in a rebuttal to Lounsbury’s article in the second part of this Great Debate©.
The Bond Bubble Top Will be Broad
by John Lounsbury
A couple of weeks ago I wrote that the top in the bond market could take as long as ten years (or possibly even more) to play out. I said that there was little likelihood of the top being reached and a rapid reversal with soaring interest rates within the next two years. My thought, expressed then and still held, is that when the bond market does turn there will probably be a gradual rise in interest rates. Rather than a bursting bubble with rapid deflation, I suggested the end of the 30+ year interest rate decline and reversal to a new cycle of rising interest rates would be more like The Great Exhale (Jim Welsh).
The last time we had a credit induced economic decline was the 1930’s. In that decade interest rates continued to decline for more than ten years after the crash and a broad low for interest rates ensued all the way to the early 1950s. See the graph in the previous article.
Admittedly the political-economic situation is different now than at the time of the last world-wide credit crisis. However, we still have a crisis produced by over-leverage and such credit excesses take time to unwind. Interest rates can’t make a sustained move higher while debt is still being shed. There are still trillions of dollars of mortgage debt alone to be written off. The current policy of extend and pretend (see Treasury meeting reports here and here) will stretch that process out for many years.
David Rosenberg, chief economist for Gluskin Sheff (Toronto) states the situation well:
In this post-bubble credit collapse everything is mean reverting from P/E ratios, to savings rates, to debt/income ratios, to homeownership rates and the process is going to take more time and extract more domestic demand growth and pricing power out of the economy. We closed the 1930s with a 2% long bond yield, which makes perfect sense to us since the typical spread between the 30-year and the overnight rate is around 200 basis points. It won’t be a straight line, and based on past long interest rate cycles, which can last up to 32 years, we could be looking at a bottom roughly two years from now. So we wouldn’t quibble with the view that the secular bull market in bonds is in the mature stage. But it ain’t over yet.
Until there is a demand for credit, interest rates will not rise. Right now the supply (provided by the Fed and the government) outstrips the demand. Right now we are in the process of available credit (Fed and government) being used to write off losses on bubble credit. A balance must be restored between supply and demand for “price” (i.e. interest) trends to change.
The Bond Bubble Could Burst at Any Time
by Ted Kavadas
Lately there has been much commentary on whether the bond market is in a bubble. While many believe such a bubble exists, others – including many prominent investors and commentators – disagree. John Lounsbury recently expressed similar views about a bursting bubble not being imminent. I must disagree.
As I have previously written, I believe that there is a bond bubble encompassing the entire bond market. While for many reasons one might not expect the bond market to become a bubble, nonetheless such a bubble has occurred and it is now simply enormous. This bond market bubble stands out from other bubbles in history in both size and duration.
As one can see in the chart below, from Doug Short’s site on 10-4-10, the 10-Year Treasury Yield (blue line) has been on decline since the early ’80s:
This decline in bond yields has been exceedingly munificent to the economy in many different ways. As well, the bond bubble has been very beneficial to a range of asset classes. On the above chart, one can see the performance of the S&P500 in green during this period of falling interest rates.
Of course, if one believes the bond market is a bubble, then a pivotal question becomes when will the bubble “pop?” This question is difficult to answer, as there is a complex interaction between various factors fueling this bubble.
One important factor is that of additional Quantitative Easing (QE). Many believe that such efforts will further depress interest rates. Various estimates seem to generally support the idea that $2 Trillion of additional QE would depress 10-Year Treasury rates (currently at 2.48%) by approximately 100 basis points. While I believe that such an effect may be possible, it is likely such an impact is overstated. One question that looms large is whether any rate-suppression effect that additional QE may have is already “priced into” the market, as additional large doses of QE has been widely expected for a while now.
Another factor that is pivotal in assessing the longevity of the bond bubble is whether there is excessive “froth” in the market. “Froth” is often seen during the terminal stages of asset bubbles. This “froth” often manifests via very strong money inflows and a general lack of heed regarding risks, both apparent in this bond market. As well, although difficult to “prove,” the bond market seems to have the “feel” of a self-feeding mania, which was seen in other recent bubbles such as the NASDAQ and Internet bubbles of the late-90s, as well as the housing bubble.
For many reasons, it is tempting to conclude that the bond bubble will last for years. In fact, I am not aware of anyone who is predicting its imminent demise, i.e. “popping.” However, I believe, from an “all things considered” basis, that the “popping” of the bond market will happen in the short-term (i.e. likely within 6 months, and possibly even yet in 2010). I make this judgment based upon many different factors. Such a bursting of the bond bubble will have immense negative ramifications on many levels.
Another critical issue with regard to the bond bubble is the following: If one believes that there is a bond bubble that is serving to unduly depress interest rates, what might be the “natural” interest rate – i.e.one that may endure after the bond bubble pops? This is an issue that deserves contemplation.