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Bond Market Twilight Zone

 June 13, 2012 03:42 PM

(By Random Roger) Bloomberg had a lengthy write up looking at the extent to which many sovereign bond markets have been distorted by a long list of variables including policy measures to promote growth and fear-based buying. The article attempted to explore whether this is a bubble or not and whether yields will remain low or go much higher, hurting investors. The article even includes "new normal" talk from PIMCO.

My take has been that prices are very high but could stay high for quite a while. I believe the fundamentals call for much higher rates which I would have thought would have started by now but obviously that has been incorrect. The Fed is planning to keep rates low for awhile still and no one should be surprised if low rate policies continue to be extended.

Germany, Japan and Switzerland have lower rates than the US does. Someone tweeted out yesterday that Swiss five year paper had a negative yield. While I could not find a quote on five year paper, this page from the SNB seems to have the Swiss ten year yielding 0.58%.

Many are calling this a bubble which is probably not the best word but the article had a great line from Blackrock noting that bubbles are about greed and the current bond market is about fear, people want to preserve principal.

This makes a lot of sense in terms of helping to understand the current dynamic but doesn't necessarily provide a look forward. If bubble is the correct word then that implies it will end badly with yields going way up and bond prices (and bond funds) going way down. If Blackrock is correct then they are obviously describing a fear based trade and at some point the fear subsides. When fear does subside does that not also result in yields going up a lot? That is obviously the debate and of course desperate policy in many countries are going to be around for a very long time so there may be no consequence either way for years.

Desperate policy can end before we get to 4% GDP growth and when it does end then it would make sense to expect fundamentals to matter and if the fundies to ever come to the fore then yields should go higher. This is the obvious risk, it may or may not ever matter but it is the obvious risk and avoiding the obviously risky is not the worst thing you will ever do.

One amusing note, the world is very worried about Spain, and rightfully so. At one point yesterday the yield on Spain's ten year was 6.8%. In the summer of 2006 there was a brief window where the US two year yielded more than 5%.


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