11/23/2020
Whether or not an asset class is in a bubble is difficult to answer in real-time, since sentiment can change course as quickly as a few weeks, or take years. In hindsight, these things are always more obvious. The question can be viewed through a few different perspectives:
(1) Bonds are cheap, and have room to run. Unsurprisingly, at current low rates, this camp has relatively few believers. For this story to make sense, it would require an assumption that the economy is perhaps moving toward a second recessionary downturn (where rates would fall again, helping the returns of long-duration bonds), or longer-term deflation, that could drop rates lower than they are now for an extended period. The probability of these scenarios is never zero.
(2) Bonds are expensive, or even in a bubble. This has been the argument made by more bullish economists and investment managers for at least a decade, since the Federal Reserve lowered short-term interest rates down to zero during the Great Recession, and again more recently during the pandemic. Although U.S. treasury bonds are considered ‘risk free’ from a credit default standpoint, they’ve historically offered some premium for other risks: changes in inflation expectations, tying up money for a period of time, and some degree of lessened liquidity (at least compared to cash).
Market interest rates flow from a combination of these factors, pushing up bond prices and pulling down yields when investors have few inflation fears, an appetite for income, and/or a need for safety. On these metrics, a 10-year treasury bond yielding under 1% looks expensive when looked at through past metrics. Using a long-term central bank inflation target of 2%, plus a traditional demanded real yield of at least 2%, we end up with a rate somewhere near 4% looking more historically appropriate. It may not be logical to assume a quick snap-back of rates to that level anytime soon, but through that view, current rates appear low, and bond prices rich. (It’s important to acknowledge that investors have been waiting for this to occur for at least decade, while yields moved in the opposite direction—far lower.)
What could cause a bump up in rates? If truly a coiled spring, theoretically, it may not take a big catalyst—higher realized inflation, rising inflation expectations, or the increased federal deficit and overall debt load causing investors to demand a higher premium over the current rate.
(3) Bonds are fairly valued (status quo). As noted, yields are tied to current or future inflation, which is in turn connected to longer-term economic growth. Real yields can diverge widely from a long-term average, based on monetary regime and investor demand. The buying of treasuries and agency mortgage-backed bonds by the Fed and other global central banks has pushed demand up and yields down, creating artificial market dynamics. But, these persist without any signs of an ending point, especially due to the economic damage caused by Covid. The shift in interest rates downward globally hasn’t helped, especially with the unique situation of the U.S. acting as the world’s safe haven, but, at the same time, also offering higher rates than in alternative regions—notably Japan and Europe. From that perspective, a long-term treasury rate of 1% looks attractive to global buyers relative to yields of 0% or -0.5% seen elsewhere.
Less optimistic economists see low rates inextricably tied to slower labor force growth, low levels of investment, and potentially diminishing productivity, the combination of which has depressed long-term GDP growth. Such a scenario could hold down inflation and future inflation expectations (and actually has held them down, during the entire time it’s been argued about). This perhaps worries the Fed the most. In this scenario, growth setbacks or financial market volatility raising the demand for bonds could pull rates down again to new lows. In a small example, 3-month treasury bill yields have fallen below 0% briefly, as investor demand for short-term safety and liquidity drove prices beyond par—it’s easy to see how this can happen when looking at yields from a simple auction supply/demand perspective.
The debate is ongoing. Status quo is difficult to bet against in the near term. Arguments over rates are perpetual, and have certainly persisted over the past decade, with little clarity as rates have moved in a band of several percent in either direction. Markets themselves provide the right answer, if one believes they’re priced at least moderately efficiently at any given time.
While several foreign regions have moved into policies of negative rates, the U.S. Fed has resisted this, noting the lack of proven effectiveness and negative repercussions on certain segments of the U.S. financial sector (it might render the very large money market mutual fund industry unviable). With little else at their disposal other than lowering policy rates to zero, bond buying, and continued forward guidance about the accommodative low rate stance staying intact for longer, one could see the current environment being in place for a while, absent any upward or downward shocks. In addition to government bonds, corporates of course have their own spread dynamics, offering better rates than treasuries, but also a tighter correlation to equities.
Regardless of opinions about rates and their future direction, bonds have always played an important role in asset allocation portfolios. Taking extreme bets on either outcome over short periods can end up being very correct, or very incorrect, as conditions change. At the very least, large bets raise tracking error and potential volatility relative to one’s target. Most importantly, the stock/bond decision remains among the most critical ones in determining an investor’s risk tolerance. The portfolio risk component is determined almost overwhelmingly by equities, putting bonds in the traditional role of risk mitigation and chief diversifier. (In terms of asset classes, long-term treasuries remain among the lowest-correlated assets to equities, particularly during financial market sell-offs. This is despite their own tendency to be very interest-rate sensitive in their own right, particularly when used by themselves.) With low rates, the diversification effectiveness may be lessened along with lower expected returns, but they remain present to at least some degree. In recent years, a quarter- or half-percent has never meant so much.