US Bond Market Bubble? Fund flows indicate yes

According to the Investment Company Institute, investors have poured almost US$ 375 bn into bond funds since the start of 2009 and in aggregate there is more than US$ 2.2 tn invested in bond funds. This massive inflow of money into bond funds and the government's purchase of government bonds as part of its quantitative easing program has made yields in the bond market come down substantially since late 2008. These bond flows are all not done wisely. Quite a bit of it been speculative and based on naïve misplaced notion that bonds are less risky. As a Societe Generale report of January 2009 notes, such investors are in for a bad surprise when rates rise in the second half of 2010 and yield curve flattens. Ditto when the ISM picks up and GDP growth sustains itself above 2.5%, bond yields will go down.

Is it a bubble then? As CNN Money opines rather correctly, the answer is nuanced. From a longer term perspective, bonds are, broadly speaking, at near all-time lows in yield. In particular, given the current loose monetary policy being implemented by the Federal Reserve, Treasury bonds are at close to all time lows in yield, and therefore highs in price. Given this extreme in Treasury bond pricing, there is clearly bubble potential in the U.S. government bond market.

Currently, 20% of all US mutual funds comprises of bond funds. The picture gets starker if the flows are considered from December 2008. Billions have exited the equity markets and have gone into bond markets. Eventhough 44% of all mutual funds are equity funds (44% of 11.1 trillion AUM in the US), outflows have been greater from equity funds on a net basis. According to Michael Belkin since last March on an average bond market funds are seeing inflows of US$ 4 bn a week while equity funds barely manage US$ 500 mn a week.

The Bond Bubble term has been bandied around for the past three years. While it is easy to make a call that an asset class is in a bubble, it is more difficult to predict timing of such a call. In addition, a bubble inherently implies that the unwinding of that bubble will be a crash. So far both have not materialized.

Charting the spread of corporate junk bonds bond versus 5-year treasuries and corporate investment grade bonds versus 5-year treasuries going back to 2002, while yields for both investment grades and junk bonds are close to their lows in yield for this period, currently at approx 8.24% versus their low of 7.75% for junk bonds and 4.7% versus their all time low of 4.5% for investment grades, the spreads between 5-year treasuries remains relatively wide. In fact, these spreads bottomed in 2007 at 0.93% for investment grade and 3.1% for junk, versus their current spreads of 2.30% and 5.74%, respectively.

The case for a US Treasury Bond Bubble: Since the price of bonds should never be taken in isolation, if there is a bubble in bonds, it is likely related to Treasuries. The case for the Treasury bubble is effectively three-fold:

1. They are being priced based on extreme monetary policy that will not be sustained in perpetuity.

2. They are incorporating very limited expectations for inflation, which we believe will occur and perhaps in dramatic fashion.

3. Finally, government bonds will eventually have to reflect the declining credit worthiness of the US based on the United States' deficit as a percentage of GDP and growing debt to GDP ratios. After health care commitment deficits have crossed 10% of GDP

Treasury bonds cannot stay at their current yield level forever. And while we have seen some correction, yields and prices for U.S. government bonds are still at generational extremes. In reality, though, just as it took decades for interest rates to come down from the meteoric highs of the 1980s, it will take interest rates time to go up, and it is likely that no crash is imminent. So even if there is a bubble, there won't likely be a "pop." This move will be long and sustained.

As CNN Money notes, from an investment perspective, the most effective way to play the re-pricing of Treasuries over time is to be short Treasuries out right, or to play a narrowing of the spread between treasuries and corporate bonds.

Small Note on Greece: While unrelated, however, Greece indicates the dangers of high bond market yields reducing equity flows as the markets are connected. Higher yields make bonds attractive and affect fund flows into equities. This will be discussed separately.

Is the Fed risking Inflation to continue to support the Recovery?

The Fed said in a recent meeting that, Inflation concerns were benign and that it would keep rates lower for an extended period. Jason Cummins of Brewan Howard Asset Management noted that 50% of the consumer Index was in deflation region. However, I find that a bit contradictory because 60% of the US CPI index has been rising in the last year while the 40% represented by rent/shelter had dragged it down (see the graph later in the post for CPI excl. rent component). Then I saw the US PPI data and that points to what I feel is an oncoming rising inflation cycle. I disagree with Cummins' conclusion while sharing his view on the Fed having real tough policy choices..anyway back to Inflation and the PPI....

Example: US PPI went up unexpectedly in March, rising 0.7% against forecast 0.4% and February’s -0.6%. This translates to over 6% on an annual basis in March 2010. With core CPI rising by nearly 1% YoY, with much of the increase in prices is related to rebound in commodity prices (viz. food and energy), there is a risk that this temporary inflationary surge translates into a more generalized pick up in inflation and inflation expectations. This could have the impact of rising wage and salary costs even as unemployment remains extremely high. Thus the risks for US inflation remain to the upside. (part of this is from marketwatch)

This is where Jim Bianco's take on Inflation becomes very interesting. As mentioned earlier, Bianco correctly says that the 60% basket of the CPI comprising food, gas, utilities etc.. have been on the uptick since the last 3 quarters as commodity prices have rebound.

Whats the bad news?

Well, the other 40% namely rent/shelter was kept low through Government tax credits for housing causing rental demand to slow down. With this measure expiring today, the demand for rentals will move upward. Thus the 2.3% figure quoted by Bernanke is at best incorrect. The US CPI should move into the 3% territory around end June 2010 as the effect of the tax credit begins to die out.

This only leads to one conclusion...

The Fed is risking higher inflation to sustain growth (The Fed or any central bank has one basic question in front of it always: do i foster growth ot stabilize prices?). The Fed is soon going to face the fact that the above objectives will go in the opposite direction shortly. The policy dilemma seems to go the way of low rates atleast till December 2010.

In my opinion, We might see a hike in the fed funds rate in Jan or Feb 2011. But if you see my tail-piece below, you may realize why the Fed is in a tight spot..

My conclusion is also connected to three other elephants in the room: soaring deficits, looming bond bubble and potential damper of Fed action on equity markets. Each deserve a separate post.

Tail Piece:
(Policy is also complicated due to the amount of long-term mortgages held by the Fed. A rate hike might end up undoing the Fed's efforts to help banks...we will see that in another post)