How Long Will This Bond Bubble Last?

There's been a lot of talk of bubbles lately, including speculation on where the next one lies. Some say it's in the energy sector, while others claim that gold's a bubble. Here's our nomination: bonds.

Our proxy for fixed-income is the ever-popular 10-year Treasury, the benchmark for U.S. debt markets and in some cases foreign markets too. Exhibit A in our bubble thesis is the chart below, which shows the daily closing yield of the 10-year for over 40 years (including Tuesday night's close). Restating the graphically obvious: the great decline in yield for the past 26 years. Since the peak of 15.84%, set on September 30, 1981, the 10-year Treasury's yield has, with fits and starts, become a shadow of its former self.

As of Tuesday's close, the 10-year trades at 3.61% - a tidy 1200 basis points below the 1981 summit. In fact, that's not the lowest yield in recent memory. In June 2003, the 10-year yield briefly dipped to 3.20% (measured by daily closes) and to 3.09% on an intraday basis. As we wrote this, those troughs are theoretically just a few trading sessions away - if the bond market is willing.

So far, the fixed-income set has seen fit to follow the Federal Reserve down the slippery slope of fading rates. That's unsurprising, given that falling rates are the fuel that's lifted bonds to the upper levels of the performance horse race among the major asset classes. No wonder, then, that bonds generally have been faring well recently in relative and absolute performance terms. Through Tuesday, the iShares Lehman Aggregate Bond ETF (AGG), for example, boasted a 2.5% total return, and 8.9% for the past 12 months. Inflation-indexed Treasuries and foreign bonds in developed markets, along with the broad commodity indices, have done even better over those time frames. Otherwise, lesser performance and red ink prevail among the major asset classes.

It's anyone's guess how long the bond party can roll on, but there's no getting around the fact that a bull market that will mark it's 26th anniversary come this September 30 is no spring chicken. At the same time, the bond bulls are encouraged by their patron saint, also known as, the Federal Reserve. And at the moment, there's still reason for cheer. The April '08 Fed funds futures contract is current priced in anticipation of another 50-basis-point cut, and the August '08 contract expects a further 50-basis-point reduction on top of that. Hope, in short, is alive and well in the bond market.

But make no mistake: this is a dangerous game and it's not entirely clear that the long yields will continue to follow the Fed's lead like a fawn follows its mother. The key risk factor now is that the inflationary winds are blowing. Yes, the absolute level of pricing pressures still looks low by historical standards, but the long slide in inflation may be over. That doesn't mean that we're about to suffer a sudden surge in prices generally. But once the bond market embraces the idea that inflation risk is rising, if only marginally, then the bond bubble (if we can call it that) may burst.

Of course, all bets are temporarily off if the economy weakens dramatically from here. If the slowdown is deeper and longer than the crowd expects, the party in fixed income may roll on. More than a few bond investors are expecting no less. But that will only delay the inevitable. Nominal yields can only go to zero. Practically speaking, the bottom in the 10-year's yield will probably be much higher. We don't discount the possibility that the 10-year Treasury may trade below 3% at some point this year. The real question is: What are the odds of 4%?

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