The Treasury Bond Bubble

Eddy Elfenbein at Crossing Wall Street has put forth the concept of a “bond bubble” over at his blog. I support the concept in part, but I need to modify it. Let’s call it a Treasury Bond Bubble, because other classes of intermediate term debt have significant yield spreads over Treasuries because of the current economic volatility.

Should 2-year Treasury notes yield less than CPI inflation? No, and CPI inflation is not going down. Scarcity of food and fuel are normal conditions in our growing world. We can only extract so much out of the planet in the short run. Why lend to the government at a loss? Better to invest in a money market fund, or perhaps, the stock of a business that is inflation-sensitive, or TIPS.

Can 2-year yields go lower? You bet they can. The Fed is flooding the short end of the yield curve with liquidity for now, until inflation pressures become intolerable. In the present political environment, the Fed is incented to loosen, even in the face of rising inflation. Remember my “pain model” for the Fed. They move in the direction that avoids the most political pain. People are screaming over a weak economy now, and no one complains about inflation. Thus they loosen. How much at the end of January? Uh, that is up for grabs. My view of the Fed is that they want to drag their feet, because they see inflation rising, so even if Fed funds futures indicate a 75 basis point cut, my current view indicates 50 as more likely, again, with language in the statement that indicates even-handed risks.

One final note: the concept of a bond bubble sounds a little like the Austrian school of economics. The central bank pushes interest rates below the natural rate of interest (i.e., the one that would exist in an free market equilibrium), in order to stimulate the economy. Bonds would be worth more than their long-term intrinsic value in such a scenario. That’s true today, with one modification, because of the credit stress, only the highest quality borrowers get those rates.

Comments

[Michael B.Krause]

Good points.. The bond bubble is just that, but will of course occur at the expense of every asset class.

I too think bond prices (like you say) are a function of a ton of cash seeking a safe, 'politically correct', home --- more than correctly gauging inflation. You could say a function of increasing money supply to address aggregate demand and bank reserve requirement issues (which the fed and other central banks manage/interact with).

The long bond is saying that we are at the end of this round of inflationary spike, if you are to infer any message there. My hunch is that the long bond will start to break current resistance when it sees crude oil plummet. Crude oil will guide most of the entire commodity complex (ags and most energy at least), since so much of the world foodstock issues are dictated and correlated by crude demand [oversimplification: corn is overplanted due to ethanol subsidies, wheat and soy complex becomes underplanted, etc etc].

[nickgogerty]

CDS counterparty risk and muni bond insurer relatd downgrades, make me want to run to the short of the curve for awhile.

[Reinko]

Ah the Austrian school, so charming. Just so charming... But I think when you adopt their ideas you can get allocation problems for money.
On the other hand, what the Federal Reserve is doing the last years is also utterly crazy; M3 money supply growth runs at 17% or so. Therefore one thing is clear: Because this is so much above GDP growth and inflation, there must be a lot of bubble money...

And when you see all those Wall Street traders running from stocks to bonds and vice versa (depending on the economical news) it looks indeed there is a lot of bubble money going round at Wall Street.