John Shmuel | Financial Post Nov 23, 2012
There was no shortage of analysts ringing alarm bells when bond yields hit record lows this summer. They argued rock-bottom interest rates wouldn’t last for long and investors would get burned as a result. Many market watchers labelled the flood of money into the bond market as a “fear trade” driven by panic that a possible eurozone breakup and another global recession were around the corner.
Five months later, the macro picture has stabilized, with an unlimited bond-buying program from the European Central Bank cooling concerns that a eurozone collapse is inevitable. But bond yields still remain close to historical lows, suggesting investors are as fearful as ever. The amount of money flowing into bonds is staggering. Research by J PMorgan shows US$2-trillion has flowed into fixed-income funds around the world in the last four years, compared with US$400-billion into equity funds.
Naturally, when that much cash pours into a single type of asset, the bubble word starts getting tossed around. Last week, Sheila Bair, former chairman of the Federal Deposit Insurance Corp., warned the U.S. Federal Reserve is creating another financial crisis with its quantitative easing policy. She said the sheer amount of money flowing into the fixed-income market is creating “the mother of all bond bubbles.”
The idea is gaining steam among some analysts and, certainly, the media. But John Lonski, chief economist at Moody’s Capital Markets Group, points out analysts have generally been wrong in the last two years when forecasting what the bond market will do. “The truth is, the consensus on Treasury yields has consistently overestimated their targets,” he said.
For instance, he points out that economists in January 2011 projected 10-year U.S. Treasury yields would average 4.2% in 2012. Instead, it looks like the average yield will likely be around 1.8%.
Investors should also remember that the bond bubble alarm has been raised continuously since the start of the financial crisis. Warren Buffett, for instance, in early 2009 called the fall in yields “extraordinary” and cautioned that economists would one day regard the “bond bubble of late 2008” with the same level of astonishment as the mortgage bubble of 2007 and the Internet bubble of 2000
Of course, Buffett’s bubble prediction never came to be. But that hasn’t stopped speculation there is one coming. For one thing, even though it seems impossible for yields to go any lower, investors continue to pour their cash into bonds. Ten-year U.S. Treasuries on Friday were yielding 1.70%, not much of a return for money you must lock in for 10 years. Canadian 10-year bonds yielded a similar 1.77%.
The ultra-low yields are not far from the record lows experienced in July, when 10-year Treasuries bottomed out at 1.4%, the lowest in their more-than-200 year history. Even then, investors, scarred by the financial meltdown and resulting effect on equities, continued to move money into the relative safety of bonds.
But Ian Pollick, a senior fixed-income strategist at RBC Capital Markets, notes that it’s more than just fear that has pushed investors into bonds. The market has become an incredibly strange environment where investors are buying bonds for capital appreciation while using stocks to get yield in the form of dividends.
One of the biggest potential downsides to such activity is that when interest rates do finally rise in the developed world, presumably when the economy turns around, government bond prices will drop since they move inversely to interest rates.
But the U.S. Federal Reserve continues to push back its target for when it plans to raise interest rates. The current outlook calls for the Fed to start hiking rates in mid-2015. Canada’s central bank was also less hawkish in its most recent monetary update, suggesting the prospect of higher interest rates may also be kicked down the road.
“Clearly, when you look at the bond market and see yields at such extremely low yields, it’s pretty evident they’re not going to go much lower,” Mr. Pollick said. “But given what’s happened in the past two years, you start to ask, ‘Or can they?’ You’re in a world that has a very volatile macro backdrop and you have the continuation of a lot of abnormal monetary policies abroad.”
While he doesn’t expect bond yields to move lower, he notes the current global economic environment presents very few catalysts on the horizon that would cause yields to suddenly move upward.
“There’s a higher probability that yields rise before they fall, but if you look to next year, there is still a sufficient amount of risk in the backdrop such that yields may not trend decisively lower,” Mr. Pollick said. “But even if they start to rise a little bit, it’s not necessarily a signal that it’s a bear market.”
Stephen Lingard, managing director at Franklin Templeton Multi-Asset Strategies, doesn’t see a bubble in the bond market either. His view, however, is that the government bond market is certainly overvalued, but that doesn’t mean investors should avoid it.
“From a diversified standpoint, I think bonds will continue to earn a positive return in the long term, even starting at these levels,” he said. “Sure, they are going to earn a below historical rate of return, and maybe even a negative rate of return over short time periods. But over a reasonably long time period, we still think they make sense.”