Saturday, June 13, 2015

Bonds and bubbles - are we seeing the reversal?

The market talk in a number of circles has been that we are in a bond bubble, so the current sell-off is the pricking of that bubble. It is always hard to tell whether you are in a bubble. There is mp set definition. This is one of the main reasons central banks have avoided dealing with them.

However, some have said there are set conditions necessary for a bubble and it can be argued that we have seem most of them in global bond markets.

Conditions for a bubble:
1. There is a new paradigm and convincing fundamentals or at least it is hard to compare the current environment to the past.
2. Surplus liquidity
3. a demand/supply imbalance
4. business/benchmark risk for asset managers

For the global bond markets in the developed world, we have had all four conditions. The new paradigm or conditions for holding bonds is secular stagnation and deflation. There is convincing evidence for both stagnation and deflation which makes for a compelling story for holding bonds. This new paradigm is hard to compare to the past, so the stories of today seem right for investors.

There is plenty of surplus liquidity even if it is not coming from the Fed. Other central banks are providing the liquidity to allow a bond bubble to continue.

There is a demand/supply imbalance based on the excess savings of consumers and the austerity of governments. There has been a shortage of high quality safe assets for investors.

The strong performance forces asset managers to buy assets that have been going up in value. There is a classic momentum effect in the bond market until this quarter.

That said, the recent sell-off suggests that the conditions for the bond bubble are being questioned in a manner different than last year. The inflation is still below the 2% target but deflation is more suspect. Growth in Europe and the US is not as bad as thought at the end of the first quarter,

The Fed talk of raising rates could impact liquidity although the Fed has not talked deeply about how it is going to reduce its balance sheet. More consumer spending, greater bond issuance, and less stretching for yield will reduce the supply/demand imbalance. The recent decline in bond performance will be causing asset managers to rethink their current asset allocations.

The bond bubble may continue with this quarter being just a temporary adjustment, but more likely we are seeing a big bond unwind with investors starting to balk at yields that do not compensate for their risk.

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