Bubble spotting in bond markets may be a wasteful endeavour
Current market conditions attract lots of commentators prepared to spot another period of insanity
We are cursed to live in interesting times: a surge in Greek bond prices is directly linked to rising house prices in Dublin. But health warnings abound.
Current financial market conditions attract lots of commentators prepared to spot another period of insanity that can only end badly. Greek and Spanish bonds, London and South County Dublin house prices, US equity markets: all are widely described to be in a bubble. And these are not the only assets thought to be wildly mispriced. John Mauldin, a well-known Cassandra, is typical of the times: his latest investment newsletter offers us “three ways to protect yourself from the bubble”. There are plenty of others like him.
Current market conditions are widely described in terms of a ‘search for yield’. And, on this analysis, it is all the fault of central banks, particularly the ones engaged in quantitative easing (QE). The policy of buying vast quantities of bonds has had the effect of driving bond yields down way below historic norms - or, indeed, levels that are consistent with underlying economic fundamentals.
Almost in the blink of an eye, Greek bonds, recently perceived by investors as toxic are now on every hedge fund’s must-have list. Likewise, terraced houses in Dalkey. There is, believe it or not, a causal connection between the two markets: the same factors are driving them.
The ‘search for yield’ is also described in terms of investors suddenly rediscovering an appetite for risk, one that was lost during the financial crisis. And, as with all such swings in market sentiment, it has gone too far; nemesis awaits those who get sucked in.
Bond markets are all important here (as we discovered, they always are). Those who argue bond yields really are too low (the same thing as arguing that bond prices are too high) have to confront an uncomfortable fact: bond yields have been too low for too long. If things were really that unsustainable, they would - should - have changed by now. In Japan, all of these arguments have been rehearsed not just for years, but for decades. Some investors have spent their whole careers wondering when Japanese bond yields will start to get back to ‘normal’ levels’. All of this bubble spotting in bond markets is horribly reminiscent of the wasted years - decades - spent forecasting a rise in Japanese yields.
An alternative narrative is that bond yields are currently correct. And because bond yields determine every other asset price, this has huge implications. Take, for instance, a buy-to-let investment somewhere in South Dublin. If the sustainable rent is €2000 per month and the ‘right’ bond yield is 5 per cent, then, in a simple, stable world, the correct value of the property in question would be €480,000. If, for some reason, the right bond yield is deemed to be 3 per cent - not too far from current government bond yields - the property’s value would rise to €800,000. There are simplifying assumptions and a straightforward bit of arithmetic underlying all this but the message is clear: sustained changes in bond yields have a huge impact on asset prices.
The doom merchants point to debt levels - they remain too high for comfort. But this analysis, while true for some countries (including Ireland), ignores the simple fact that the large chunk of US and UK sovereign debt now held by the Federal Reserve and the Bank of England has effectively been cancelled. It will never be paid back. It is not just Greece that has had a debt restructuring. We can only look on in awe and envy.
It is possible - just - that we have entered a world of low but stable growth with little or no inflation; one that, maybe, justifies low bond yields and higher real asset prices. Even if any of this is true, it represents something of a knife-edge, one with plenty of ways to fall off. Growth may disappear or be highly volatile. Inflation could misbehave in either direction. Things will probably get messy - but the lesson of Japan is that things can also get pretty strange. And stay that way for a very long period of time.
The upshot of all of this is that we have to indulge in mental contortions of a very unusual kind to rationalise the current levels of the US stock market, Spanish bond prices and the wall of money chasing commercial property in parts of Dublin. All of this could last a while. But proper investors will not want to chase these latest fads.