Treasury bond bull market is erroneously classified as a "bubble."
Bubbles are a phenomenon based solely on unmitigated greed.
Demand for T-bonds is now driven by fear, hence there is no bubble.
One of this year’s biggest myths is the belief that the U.S. Treasury bond market is in the midst of a speculative mania. This widely held belief is capsulized in the term “bond bubble” and is one of the Wall Street media’s favorite narratives. The idea behind the bond bubble is that another financial market collapse is imminent due to the excessive credit generated by years of quantitative easing by the Fed.
As I’ll show here, however, the bond bull market is based on fear, not greed, and therefore can’t be categorized as a bubble. I’ll also argue that when the bond bull market finally ends it will take the form of a gradual unwinding, not a sudden collapse.
Ever since the implosion of America’s last true mania – the mid-2000s housing bubble – financial pundits have had a paranoid tendency to see bubbles at every turn and in virtually every market. The problem is that this paranoia has been without basis as there hasn’t been a true bubble since the housing market collapse.
While there is no universal agreement as to what precisely constitutes a bubble, the general consensus is that a bubble is a phenomenon based mainly on greed. Bubbles are synonymous with speculative manias. And the essence of a mania is insatiable desire to own an asset at any price for the sake of capital gains, regardless of the asset’s underlying value (or lack thereof). In other words, a bubble involves a mindless greed for buying something solely for the sake of a quick and easy profit.
Is mindless, unmitigated greed the primary motive behind the relentless rally in bond prices? Many observers seem to think so. One such example is former Texas Congressman Ron Paul, who recently told CNBC:
I can’t tell you exactly how bad it’s going to get but it’s going to get bad, because we’ve never been here before. Predictions don’t mean a whole lot and we’ve never had as many currencies at negative interest rates. Seventeen trillion [dollars] worth of bonds, negative interest rates. It’s never existed before. And that’s a bubble. So we’re in the biggest bond bubble in history and it’s going to burst.”
The temptation to classify any sustained bull market in financial assets as a “bubble” is tempting, yet hardly helpful – especially if the term hasn’t been properly defined. What makes a genuine asset bubble potentially dangerous is the aforementioned presence of greed. Greed as an emotion can be quickly supplanted by fear. When reality finally dawns on the participants of a financial market bubble, and they realize that there is no rational basis behind a continuation of rising prices, they’re quick to sell. The collective nature of a bubble mentality is such that a selling panic can spread very quickly and translate into a rapid plunge in the asset’s value. This is why bubbles tend to end with a massive price collapse, as opposed to a gradual, drawn-out decline. Greed is quickly supplanted by fear.
Everyday experience teaches us that fear is a much stronger emotion than greed. Greed has its limits, while fear does not. The great irony of the bull market in U.S. Treasury bonds since late 2018 is that it has been driven mainly by fear. Investors have especially been worried over the potential for the U.S.-Sino trade war to result in a global economic recession. This fear has catalyzed a huge demand for the relative safety of U.S. Treasuries as investors the world over have treated U.S. sovereign bonds as a safe haven for their money.
That the bond bull market is driven by fear can be proven by noting that each time the trade war has flared up in the news and stocks are sold, there has been a panic-driven rally in T-bond prices. Note for instance the tendency for declines in the benchmark S&P 500 Index (SPX) to be accompanied by rallies in the iShares 10-20 Year Treasury Bond ETF (TLH). This illustrates the close connection between investors fleeing from risk (stocks) and into safety (bonds).
Unlike greed-driven asset bubbles, bull markets which are driven by fear are far more likely to unwind in a slower, more orderly fashion. The reason is that while human emotion tends to switch very quickly from greed to fear, while fear – once it has become firmly entrenched in the mass psyche – is relieved only gradually. It takes time for investors to become completely convinced that the object of their fear is no longer a threat. For this reason, when the bond bull market finally ends it will likely take several months to unwind. After all, the safety-oriented mindset has been fairly widespread in the years following the 2008 credit crash. It’s no coincidence that T-bond prices have been in high demand for much of that time. Therefore, the fear mentality isn’t likely to evaporate anytime soon.
Turning our attention to the immediate-term outlook, there’s no denying that a degree of weakness exists in the market. In particular, the incremental demand for bond ETFs (Treasury, corporate, and municipal) has been waning on a 4-week rate of change basis. The following graph shows the extent of this decline. It measures the momentum of the new highs and lows in the most actively traded U.S.-listed bond ETFs. The declining trend visible here is a sign that demand for bond ETFs – and presumably for the underlying Treasuries – has dropped off in the last few weeks. This is likely a consequence of the “wait-and-see” approach that many investors have taken to the ongoing trade negotiations between the U.S. and China.
However, it should be noted that despite the extent of the decline in the above indicator, bond prices have held up remarkably well. This is similar to what happened back in July the last time this indicator was in decline. Indeed, the last time the U.S. bond market had a “correction” of sorts back in July, it proved to be merely a sideways consolidation, “pause that refreshes,” in the ongoing upward trend. When asset prices refuse to decline appreciably in spite of a sharp decline in the momentum of the new highs and lows, it’s usually a sign that longer-term demand is simply too strong to allow for a sizable pullback in prices. Thus, bonds look to have powerful longer-term support right now.
To summarize, if it could be amply demonstrated that bond prices were rising because of greed on the part of retail investors, the “bond bubble” crowd would have a stronger case for their collapse scenario. Yet it’s clear that the stampede into Treasuries is a function of fear on the part of participants who are seeking protection from the potentially negative fallout in the U.S.-China trade war. And as long as the trade dispute remains unresolved, uncertainty will continue to dominate the asset allocation decisions of investors. Accordingly, Treasuries with short-term maturities can continue to be held by participants as the bond market will continue to receive a safety-related bid in the coming months.
Disclosure: I am/we are long PBJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.