Bond market bubble - really?

There was an interview with Robert Shiller, Mr. Irrational Exuberance, discussing whether the bond market is in a bubble. There are more of those stories this year. The CFA UK survey reported that three quarters of money managers surveyed believe the bond markets are overvalued. There is little research that can provide evidence to support the view that we are in a bubble. This is the problem with any discussion of bubbles. It is hard to distinguish between overvaluation and bubbles. Past models of bonds don't seem to explain current behavior, but that is not the same as evidence of a bubble. Shiller does not commit to a bubble story in the case of bonds. There are few times when we have had a large bond sell-offs and it is unlikely that conditions exist currently for a big rate reversal.

Are there signs that we are in a bond bubble? Unfortunately, the bond market does not seem to follow the usually pattern for a bubble. There is not strong enthusiasm for this bond market. Money flow has moved into bond funds and foreign investors have bought US bonds but it has been more for safety over enthusiasm. There is movement out of cash. There is fear of stocks but there is not a love of bonds.

A close look at the components of nominal yields suggest that bond pricing is stretched but certainly not at extremes. Expected inflation is below two percent and long-term growth also seems to be at the two percent level. That would suggest that long-term yields should be about four percent assuming no risk premium. Measures of bond risk premiums are also close to zero. While there can arguments for yields being higher, current pricing does not show yields at extremely stretched levels. Overvalue does not make a bubble. It may make bonds a bad investment but not a change in the hundreds of basis points.

A component of bubbles is a psychological feedback loop which help to push prices to greater extremes. Trends are reinforced with stories to justify the market direction. We have heard the "new normal" and "secular stagnation" stories gain traction, but the numbers seems to reinforce these stories that the post financial crisis period has been different, one of slow growth and inflation. These stories do not seems to fit the feedback loop scenario. Additionally, foreign flows continue as money moves into the dollar as the US rates are actually high by the standards of the EU and Japan. In fact, yield are higher than the 2012-213 periods based on higher growth.

Could there be a 100 bp rise in rates over the next year? Could we see a 200 bps rise? Both are possible and very consistent with a higher growth or greater risk premium  story; however, this kind of rise, albeit large, would be small relative to what we have seen during other periods of bond market sell-off. Bond risk is still a concern, but not the frothy levels of a bubble.