Is there a bond bubble?

Business news writers lately have been commenting on the bubble in the bond market.  Their interpretation of current low interest rates (and resulting high bond prices) is that bond yields have nowhere to go but up and that bond prices will crash resulting in great losses for anyone who owns bond ETFs or bond mutual funds.  While I agree that there is a possibility that the bond market could crash spectacularly, I think that there is another way to look at the situation.  In the interest of full disclosure, I do play the bond market but I hold bonds directly rather than as an ETF or mutual fund and I generally hold a ladder of bond maturities to maturity unless I have a great opportunity for a large capital gain.

Back in the late 1990s, I recall reading a story about a Japanese executive who had taken an early retirement package from a major car manufacturer.  He received the equivalent of $1 million and promptly invested it in Japanese government bonds which were yielding about 4 percent, generating $40,000 in annual interest income.  Interest rates soon fell to a fraction of a percent resulting in a severe drop in investment income to well under $10,000 annually making it difficult for him to survive financially in the very expensive Japanese economy.  That story was sufficiently concerning to me that I altered my bond investment strategy.

For those of you who haven't followed Japan's fall to near zero interest rates, here's a chart showing the Bank of Japan overnight rate for the period from January 1972 to October 2010:

Japan's overnight interest rates peaked at 9 percent in 1974 and early 1980 and again at 6 percent in late 1990 and early 1991.  At that point, rates dropped rapidly to the very low single digits, reaching 1.75 percent in September 1993.  Over the next 3 years, the overnight rate gradually dropped until they reached zero for the first time in March 1999.  Since that time, rates have ranged from a high of 0.5 percent in 2007 and 2008 to a low of zero percent with an average of  0.23 percent over the 11 year period from 2000 to the present.

Japan has been battling deflation over since late 1994.  Over the period from 1971 to the present, the average inflation rate in Japan was 2.97 percent with a high of 24.9 percent in February 1974 (OPEC crisis) and a low of -2.5 percent in October 2009.  During the 16 year period from 1994 to the present when Japan has been experiencing deflation, the inflation rate has averaged -0.03 percent with a maximum of 2.5 percent back in late 1997 to a minimum of -2.5 percent.  Here's a chart showing the data for time period the since 1994:

Economists hate deflation.  When consumers anticipate that prices for the goods they plan to purchase will drop in the future, they postpone those purchases.  Since the economic growth in many developed nations is driven by the consumer, any postponed purchases will ultimately lead to an economic slowdown.

For comparison's sake, let's take a quick look at the same charts for the United States starting with interest rates from 1974 to the present:

During the time period from 1974 to the present, the United States experienced maximum interest rates of 20 percent in March 1980 and minimum rates of 0.25 percent in December 2008 where the benchmark rate now lies.

Now let's look at the annual inflation rate from 1994 to the present:

Over the time frame as noted above, the United States average annual inflation rate was 2.48 percent with a maximum of 5.6 percent in August 2008 to a minimum of -2.1 percent in August 2009 during the Great Recession.  Note that the inflation rate stayed below zero for only an eight month period unlike Japan where deflation has been relatively well entrenched since late 1994.

Now to summarize the data.  Japan's economy has experienced rather severe deflation for nearly one and a half decades as shown in the second chart.  During that same time period, overnight interest rates have remained below 0.5 percent for most of the 16 year period as shown in the first chart.  Thus far, the United States economy has not experienced long periods of negative inflation (deflation) with only one eight month period of deflation since 1994.  Recently, some economists have become concerned that the spectre of deflation could be looming over the United States.  Is it possible that the American economic pattern is lagging that of Japan by 15 years?  Should a Japanese-style deflationary pattern occur, we could be in for a prolonged period of very low interest rates.  I realize that Japan is fighting unique economic battles on several fronts including the oldest population in the world and one of the lowest birthrates with both factors greatly affecting their interest rate policies.  However, should the United States follow the lead of Japan's economy, the bond interest rates that we are experiencing today could be around for a lot longer than we think or than experts tell us.  Just as in the example of the Toyota executive, investors may find it prudent to lock in a fraction of their portfolios into medium term bonds to ensure that they will receive at least a modest and predictable return on their investment over the next five to ten years especially if they purchase bonds and intend to hold them to maturity.

References:

http://www.tradingeconomics.com/default.aspx