Sometimes, folks get tired of worrying about whether stocks are in a bubble and worry about alleged bond market frothiness for a little while instead. Thanks in part to a former Federal Reserve head's recent comments, now seems like one of those times.
But this fear has popped up repeatedly during the current bull market -- and we don't think it's any more true now.
Bond bubble talk has been around for years, coming back to the forefront whenever anyone high-profile talks it up. Enter former Fed chief Alan Greenspan, who made waves for the following comments a couple weeks ago:
By any measure, real long-term interest rates are much too low and therefore unsustainable ... When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.
Greenspan isn't alone in making the case for a bond bubble. The argument goes like this: "Easy" monetary policy -- low interest rates, negative interest rates, quantitative easing, etc. -- is keeping yields artificially low, driving irrational demand for higher-yielding junk bonds. As central bankers remove this "support," yields will jump from their historically low levels. This will roil prices -- which are inversely correlated to yields -- thus popping the bubble. Commence madness.
However, this isn't how asset bubbles typically inflate and pop. In general, they form because of two concurrent developments: a fundamentally unsupported supply increase and irrationally high demand. For example, during the 2000 tech bubble, low-quality IPOs flooded the market as investment banks pushed any old slop with a dot-com name, whether or not it had a business plan, never mind revenues, to take advantage of rising investor optimism.
Investors lapped these offerings up, blinded by euphoria and convinced the good times would never end. They didn't care that these firms were racking up big losses while quickly burning through what little cash they had on hand. All seemed wonderful -- until the bubble popped and madness commenced.
This isn't the case in bond markets today. Demand remains strong, but it isn't the euphoric variety. Individual investors own them for a variety of sound reasons, including mitigating volatility and supporting cash flow.
Many institutional bond buyers (e.g., banks, pension funds, retirement plans, etc.) have a mandate to own high-quality sovereign debt. U.S. Treasurys -- already the world's most trusted asset -- are a favorite, especially as central banks gobble up supply in Europe and Japan. Overall, the demand side of the ledger is steady and healthy.
Meanwhile, sovereign debt supply isn't running out of control. For one, it is true that QE in the U.S., U.K., Japan and eurozone took some supply out of circulation in the private sector. But also, deficits in developed economies have been falling overall, which slows the pace of bond issuance.
The U.S. federal deficit has declined over the past several years, from $1.4 trillion in 2009 to $584 billion in 2016.[i] A similar story is playing out in the eurozone. Germany -- Europe's biggest economy -- actually runs a budget surplus and hasn't needed net new borrowing for three years.
And though corporate bond issuance is on its way to new records, this isn't necessarily a sign of trouble. For one, with sovereign debt yields so low, businesses are providing some supply by issuing debt to take advantage of healthy investor demand.
This locks in lower borrowing costs for businesses, giving them access to cheap capital to use as they see fit. Moreover, corporate balance sheets are healthy and flush with cash. It would be one thing if businesses were in poor shape and recklessly issuing debt.
But credit market debt as a percentage of net worth for nonfinancial corporate businesses has remained pretty steady over the past several years, even as total assets have grown -- a sign businesses are chugging along and not over-leveraging themselves.
These developments align with our 2017 interest-rate forecast. Contrary to conventional wisdom's insistence that tighter monetary policy equals higher yields, we anticipated Treasury yields to be lower from 2017's start -- a call that looks on track.
Inflation expectations remain muted, which dampens the compensation investors demand for lending to governments. Even if quantitative easing ends in Europe and the Fed starts unwinding its balance sheet, central banks will still be net buyers of long-term debt: The Bank of England and European Central Bank are still rolling over maturing bonds, and the Fed will keep doing so as well (albeit at a slightly slower pace).
Moreover, history shows no set, automatic relationship between tighter monetary policy and yields, so bond markets aren't "due" to act in any predetermined manner to begin with. Sky-high interest rates in the late-1970s/early 1980s lead people to believe today's low rates must mean-revert to something yucky.
But historically, that period was an outlier, as low-ish rates are much more the norm. If long-term Treasury yields slowly inch up to 3% - 4% over the next few years, is that a bubble bursting?
We aren't saying that will happen here -- we aren't in the long-term forecasting business -- but there is no reason we must see a sharp move higher.
Most importantly, markets -- stock, bond and other highly liquid asset types -- are well aware of "bond bubble" speculation, which saps potential surprise power.
Back in 2016, The Wall Street Journal featured a debate between two bond experts over the existence of a bubble. Our pal Greenspan made similar claims two years ago. The Fed has concerned itself with keeping an eye on bond market bubbles, perhaps why they are a staple of the "Biggest Market Concerns" articles going into new calendar years, too. This constant bubble talk tends to dampen sentiment and be self-deflating.
The time to be vigilant is when bubble warnings fall on deaf ears or are ridiculed. This isn't today's situation, for the same old false fear still garners a fair amount of attention and concern in the financial press.
[i] Source: Federal Reserve Bank of St. Louis, as of 8/16/2017.
Fisher Investments is an independent, fee-only investment adviser serving investors globally. To learn more about Fisher Investments, please visit www.fisherinvestments.com.