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By: Simon Cai

Taking a second look at the U.S. bond market.

Bill Gross, manager of the world’s largest bond fund at Pacific Investment Management Co. (PIMCO), called for the “end of a great 30-year bull market in bonds” last week because of expected future inflation caused by the excessive printing of money by the U.S. Federal Reserve in its QE1 and soon-to-come QE2 programmes. Many analysts and economists alike have arrived at the same conclusion and are now warning investors about the possibility of a bond bubble.

However, a few economists, most notably David Rosenberg of Gluskin Sheff + Associates Inc., are still bullish in bonds for the following two reasons: the risk of deflation in a period of low economic growth and the secular trend in shifting asset allocation from stocks to bonds.

Economists rightly conclude that the printing of an extraordinary amount of money would eventually result in inflation, which would eat away the value of bonds. However, deflation, not inflation, appears to pose the greatest risk to the American economy at this moment. A number of recently published statistical measures support this position. The headline rate of inflation in the U.S. is currently at 1.1% year-over-year, and the core rate excluding food and energy is only sitting at 0.8%. Many sectors in goods and services show deflationary trends and recorded price declines last month. With all the stimulating actions that the Federal Reserve has taken so far, the rate of core inflation is still increasing at the slowest pace since March 1961. If commodity prices decrease or the U.S. dollar strengthens, the risks of deflation will intensify again.

Last Friday’s GDP figures showed that the American economy expanded at an annual pace of 2.0%. While positive, this growth rate appears low considering that recovering economies at this stage of the cycle normally grow an annual pace of 5.0%. 70% of that growth was driven by inventory build-up and not by real final sales. Growth in real final sales, increasing at an annual rate of merely 0.6%, will not be enough to drive a strong economic recovery, as inventory build-up is unlikely to spur GDP growth again in the next quarter. Overall, the pace of economic recovery appears to have lost its momentum and is now faltering. With a sustained output gap and low GDP forecasts, bonds look attractive when compared to stocks as inflation does not appear to be a threat to bond prices.

In October, the Investment Company Institute (ICI) reported that retail investors withdrew $11.2 billion from equity mutual funds ($29.2 billion outflow year-to-date) and poured $24.2 billion into bond funds ($212.7 billion inflow year-to-date). Some analysts have interpreted these substantial amounts of fund inflows into bonds as another sign of the imminent bond bubble. The counter argument to these claims, presented by David Rosenberg, is that households in aggregate are currently undergoing a transition phase to correct their underweight position in fixed-income securities by liquidating their stocks holdings and shifting the proceeds into bonds.

This trend is reinforced by changes in demographics as baby-boomers are increasingly shifting their wealth into conservative bond investments that provide capital preservation and safety of income as they near retirement age. This shift in asset classes will likely continue for the foreseeable future, as households correct their underweight position in fixed-income instruments in preparation for retirement. This continued inflow of funds into bond investments is not speculative in nature and will continue to exert an upward pressure on bond prices.

In summary, the threat of a looming bond bubble appears to be overstated. While the long term risks of inflation are real indeed, the current pace of economic recovery is very weak and deflation represents a bigger risk to America as of this moment. Through analyzing recent data and understanding the shift in asset allocation by retail investors, one can make the case that the fundamentals in favour of bond investments are still solid, with growing investor demand and low inflation.

Further Reading

Disclosure: no positions

Source: Taking Stock of the U.S. Bond Market