The Treasury Bond Bubble

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Includes: BIL, IPE, SHV, TIP
by: David Merkel, CFA

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.