For most of this year, while the stock market’s been flopping around like a fish, the bond market has been steadily rising, with bond yields steadily falling. It’s hard to say exactly how much of this is due to investors seeking the safety of bonds and how much is due to the Federal Reserve consciously keeping yields low. Suffice it to say that while investors have been dumping stocks, look at mutual fund flows, the sell-side on Wall Street, those “bulls” who somehow always are somewhere telling you now’s the best time to buy stocks, have been crying that bonds are in a bubble, and that bubble is bound to burst.
It’s quite amazing that this crowd, which didn’t see any bubble in stocks in 2000, which didn’t see any bubble in housing or stocks in 2007, somehow suddenly has crystal clarity on the subject. They don’t. They’ve just been in stocks for so long, they can’t conceive of a time when stocks wouldn’t be the best investment around.
I read the best rebuttal to this argument I’ve yet to see this morning (albeit David Rosenberg has also been banging this drum loudly and convincingly) from Capital Economics’ Julian Jessop. Pay particular attention to his first line, because that sums it up in a nutshell.
An asset bubble develops when prices move far out of line with anything that could reasonably be justified by fundamentals. That was the case with dot.com stocks in 2000 and many property markets since. However, the current low levels of bond yields (and even further falls) would be consistent with the prospect of a very long period of near-zero short-term interest rates, low or negative inflation, and lacklustre returns on riskier assets that increase demand for the safety of government bonds. After all, these factors have kept Japanese government bond (JGB) yields very low for many years – much lower than the levels currently seen in the US and Europe – despite the dire fiscal position in Japan.
Admittedly, structural factors have also played a key part in driving down JGB yields, including a large pool of captive domestic buyers. But similar factors may come increasingly into play in the US and Europe too, as changing regulatory requirements and additional QE prompt both private institutions and central banks to hold more government bonds on their balance sheets.
The upshot is that we see no compelling reason why bond yields cannot fall further in the US and Europe from their current levels, without this amounting to a bubble.