What Does the Future Hold for Bonds?

 |  Includes: DIA, QQQ, SPY
by: James Picerno

There’s been quite a bit of talk about a bond bubble recently. "Are bonds in a bubble?" inquires The Wall Street Journal. SmartMoney doesn't even ask but instead declares in a headline: "The New Bond Bubble." Meanwhile, a prominent forex trader warns today in Asia Times that "a nasty popping of the bond-market bubble lies in wait for investors."

Now we all know that interest rates are low—really low. In fact, they've almost never been lower. And there's some reason for thinking that they'll stay low for an "extended period." Reasonable minds can agree that the path of least resistance in the long sweep forward is probably up for the price of money. We've discussed this possibility (probability) before…several times. Two years ago this month, for instance, we noted that bonds appeared to be in a bubble. And the evidence, it seemed, was fairly compelling, courtesy of 26 years of generally falling interest rates.

Of course, as we all now know, bonds weren't in a bubble in early 2008, even though it appeared otherwise at the time. Or maybe the bubble was overtaken (sustained?) by events on the ground later in the year. Semantics in finance is an interesting topic, but it doesn't help much for managing money. In any case, bonds prices were poised for huge gains in the year or so ahead from the vantage of early 2008. Based on commentary and track records through much of 2009, however, it seems that most investors missed the great bond rally of 2008-2009. Predicting, as they say, is very tough—especially about the future.

Two years on, bonds still appear to be in a bubble, and an even bigger one than the apparent bubble of early 2008. But as we discussed yesterday, we should be cautious about drawing definitive conclusions from bubble analysis. For one thing, defining these states of financial affairs is a slippery beast. One man's bubble, it seems, may be another man's bull market based on fundamentals.

Should we ignore the market and economic signals as dispensed? No, although we need some perspective on how to use this information in the cause of prudently managing asset allocation. For starters, let's not jump to conclusions or make dramatic portfolio changes based on the analysis du jour. It's clear that the asset mix should be managed dynamically, although exactly how and to what degree is debatable. Even the smartest analyst in the world understands only a portion of the asset pricing rules that determine expected return. The error term is always lurking and strategic-minded investors should always factor in this risk in projecting risk premiums.

As for the current bond market, the case for thinking in bubble terms may be emotionally satisfying, but what does that imply about investors who hold bonds? Are they irrational? Maybe not. Yes, interest rates are low, but so is inflation. As our chart below shows, inflation expectations are once again on the decline, albeit only slightly so far. That seems like a rational reaction to whiff of deflation in the latest update of consumer prices. (Click to enlarge)

The critical question is deciding if a new round of deflation is coming. If it is, bond returns are likely to be stellar once again, the bubble risk notwithstanding. If the deflation risk turns out to be a false alarm, however, bonds may be headed for a tumble. Yes, that and 50 cents gets you a cup of coffee, but that's how it goes. The future's uncertain. Meanwhile, investment decisions must be made in real time using lots of imperfect information, including the gray area of figuring out if the markets are correctly discounting future risk. Since know one knows all the risks that loom, or when they'll arrive or interact, mistakes will be made. Count on it.

A recurring driver of mistakes is blindly assuming that the past will extend into the future. That's especially likely (and hazardous) when trends run on for decades, as they sometimes do. That was/is certainly the case with inflation. "We have now arrived at the end of a roughly half-century economic cycle dominated by inflation, for good and ill," Robert Samuelson wrote in 2008's The Great Inflation and Its Aftermath: The Past and Future of American Affluence. "Its rise and fall constitute one of the great upheavals of our time, though one largely forgotten and misunderstood."

True enough, but as those words were written, inflation was fading from the economic scene amid the financial crisis and the deepening of the Great Recession. The case for inflation today remains questionable for the foreseeable future. Yes, higher inflation is coming, but it's the timing that has everyone guessing.

Meantime, it hardly seems irrational to own a 10-year Treasury that yields 3.64% (as of February 25) when the market's forecast for inflation over the next 10 years is a modest 2.13%, as per our chart above, and the annual pace of headline consumer price inflation is currently at a low 2.6%. Are Treasury buyers underestimating inflation's potential in the years ahead? Or maybe the market's outlook for pricing pressure is too low. We might be able to answer intelligently if we knew what's coming, and how the infinite array of economic, financial and political variables will interact in the months and years ahead. Since we don't, we need to guess. Ideally, we'll make a guess based on enlightened analysis. But since we can't be sure, we'll have to hedge our bets.

We can do so by limiting how much we commit to bonds. And if our bond allocation happens to earn more than we expect over the next year or so, perhaps we should rebalance our asset allocation by redeploying the fixed-income gains to other asset classes that haven't done as well. We can also deploy what financial economists have told us over the decades in terms of lessons for portfolio management, such as focusing on risk management for estimating returns rather than trying to predict asset class performance directly.

Are investors making irrational decisions about bonds these days? Maybe, but there's no reason you have to suspend your capacity for rational analysis about what may be coming. If someone else wants to label that irrational, that's his problem.