By Karl Smith
Neil Irwin argues that there is no bubble in U.S. government bonds:
But no bubble fears are as widespread as those for the markets for government bonds -- in the United States in particular but also in many other nations. It almost passes as a mark of seriousness to argue that Treasuries are the next big bubble to pop, the biggest in a long series that also included the stock market bubble of the late 1990s and the housing and mortgage securities bubble of the 2000s.
I'm not particularly worried that Treasury bonds are a bubble about to pop.
I, on the other hand, routinely say that U.S. Treasuries are in a bubble.
Part of the problem is that we are kind of talking about different things, though that's a bit dicey because we are definitely talking at the same phenomena. We see different things we when look at those phenomena.
For example, leading in to his statement about not being worried, Neil says this:
Of course, bond prices could drop (and, conversely, longer-term interest rates rise). But that change is more likely to occur for good reasons -- because the economy is getting back on track -- than for bad reasons, such as out-of-control inflation.
So, I am not particularly worried...
However, I wouldn't necessarily think of bond popping being associated with "bad reasons." I think it has to do with liquidity premia, which Neil addresses:
The next factor in bond yields is 'liquidity risk,' the idea that Treasuries may be harder to buy and sell in the future than they are today, that investors might have trouble getting out of their positions in the future. It is hard to imagine a world in which the market for U.S. Treasury bonds is not deep and liquid, however.
Yet this is the very reason why I would characterize U.S. Treasuries as being in a bubble. They are the deepest and most liquid market, which means when liquidity dries up everywhere else, the relative liquidity of the U.S. bond market becomes more pronounced.
It could be that the object you are sitting on is rising. Or it could be that everything else around you is falling. The dynamics are indifferent between these two things. Or, in a phrase that is meaningful to me -- U.S. government bonds don't know they are in the most liquid market.
Compare, for example, long municipal bonds to Treasuries:
The spread is rising and closing in on levels seen during the financial panic.
Now, it's of course true that state and local governments are facing ever-increasing stress. However, historically, municipal defaults have been extremely rare. Less rare, for example, than municipalities being taken over by their state governments and having their democratic process suspended. Less rare than having all educational facilities in a municipality shut down.
U.S. political institutions are simply loathe to default. I think this pattern holds for more or less all major British offshoots, and may be related to the effect of common law on perceptions of the state's responsibility. However, I would have to check.
In any case, while there could be major losses coming, a more plausible explanation is that the shallowness of the market is exposing it to liquidity concerns. In the corporate and housing sectors -- the two major areas of private investment -- we see a similar pattern. But because of gatekeeping by investment banks and GSEs, it manifests as sharply lower issuance.
Again, default risk is certainly part of what's going on, but the freezing of credit markets and institutional reluctance to trade in or accept these securities as collateral play a major role. All of that raises the relative liquidity premium of the U.S. Treasuries and of any nation or, indeed, any organization that has a lender of last resort with access to unlimited liquidity -- that is, a printing press.