The Looming Bond Bubble

We are all aware that we are living in historic times.  Interest rates around the world are at or near all-time lows as central banks use what little influence they have on the economy in a last ditch effort to promote growth.  Since getting burned by the stock market collapse in 2008 - 2009, investors have dumped nearly $2 trillion into cash and fixed income investments in a desperate attempt to avoid capital losses in their portfolios.  While this posting uses U.S.-based statistics, the same sovereign debt/bond issues and low interest rate policies impact Canadians, Australians, U.K. residents and anyone living in a nation with a prolonged period of ultra-low interest rates.

At the end of 2011, 46 percent of American households held investments in stocks or stock-based funds, down from 53 percent in 2001.  As well, I might add that many of us, myself included, who have "played the markets" for decades used to have a basic grasp of what it took to make a stock rise in value.  Consistent delivery of growing profits and a plan for the future was all that it took to make a company's share price rise.  Over the past decade, the machinations of the market have become increasingly opaque to all but a few insiders, making investing in the stock market an unquantifiable gamble, thus, the flight to the apparent safety of fixed income investments, particularly sovereign debt issues.

Back to the subject at hand.  Here is a graph showing the Fed Funds rate since the mid 1950s:

The Federal Funds Rate is the rate that banks charge each other for overnight lending.  This rate is not overtly controlled by the Federal Reserve, however, by withdrawing or adding to the supply of money, the Fed keeps the Fed Funds Rate in line with its current policy.  With the current Federal Funds Rate sitting between 0 and 0.25 percent, we can clearly see that we are living in historically different times, particularly since that rate was set four years ago on December 16th, 2008.  Prior to our current low rate, sub-one percent lows were hit in 1954 (0.8 percent), 1958 (0.63 percent) and 2003 (0.98 percent), all for a one month period of time.  For comparison, the all-time high of 19.1 percent was hit in June 1981 and, in the past 10 years, the rate was as high as 5.26 percent in early 2007.  Since 1954, the Fed Funds Rate has averaged 5.26 percent so you can see just how other-worldly the current zero percent rate is!

Interest rates have had a great impact on the prices of Treasuries.  Bond prices act inversely to interest rates; as interest rates rise, bond prices fall and vice versa largely because the interest rate attached to a given bond is fixed.  Generally, in times of inflation, interest rates rise, pushing the value of bonds down.  How much will a change in interest rates affect the price of a bond?  Here is a table that shows the impact:

Looking at the 10 year bond with a 4 percent coupon; when interest rates rise by 1 percentage point, the value of the bond falls by 7.8 percent, however, when interest rates fall, the value of the bond rises by 8.6 percent.  A 2 percentage point rise in interest rates has an even greater impact, pushing the price of this bond down by 14.9 percent while a 2 percentage point fall in interest rates pushed the price of this bond up 18 percent.  From the chart, you can also see that the longer the bond (i.e. 20 or 30 year maturity) the greater the impact of a rise or fall in interest rates on the price of that particular bond.  Unfortunately for investors, with interest rates on long bonds in the 2 percent range, there is very little chance of capital appreciation related to a further drop in interest rates.  This is what is largely different than what the bond market has experienced in the past when there has been plenty of room for rates to drop, pushing bond prices up.

Let's look at what Sheila Bair, the 19th Chairperson of the U.S. Federal Deposit Insurance Corporation and former Assistant Secretary of the Treasury for Financial Markets has to say about the current state of interest rates:

Back in April, Ms. Bair's commented on the Fed's low interest rate policy in a Fortune op-ed piece where she stated that:

"The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in. Sooner or later, the bond bubble will burst. History has shown that a structurally weak economy combined with a fiscally irresponsible government propped up by accommodative central-bank lending always ends badly. Absent a change in policies, a toxic brew of volatile interest rates and uncontrollable inflation could define our future.

As we saw in the years leading up to the subprime crisis, yield-hungry investors are taking on more and more risk. Pension managers are investing in hedge funds, and gullible investors are buying up junk bonds. Meanwhile, low-yielding assets pile up on the balance sheets of more risk-averse banks. If interest rates suddenly spike, bankers may find that the paltry returns on their loans are insufficient to cover interest on their deposits. (Does anybody remember the S&L crisis?) Most important, retirees and others who want to keep their savings in supersafe liquid investments are earning returns of 1% to 2% (if they are lucky), while inflation creeps higher, now hovering around 3%."

As my father used to say, "Hang on, we're headed for the rhubarb!".  As I noted above, many middle-income Americans have avoided investing in equities out of an understandable and very rational sense of fear.  We have been lulled into investing in fixed income investments that have the false appearance of protecting our capital when, in fact, the opposite could well be true, largely because our current ultra-low interest rate environment is unsustainable.  On top of that and even worse, these interest rates have lulled elected officials into a completely bogus sense of security, blinding them from seeing the necessity of dealing with the reality of mounting deficits and growing debts.  

Just as Alan Greenspan saw neither the housing bubble nor the tech stock bubble, it would appear that Mr. Bernanke is completely blind to the possibility that his massive experiment with QE and the Twist will be creating the world's next debilitating bubble; the bond bubble, the collapse of which could impact even the most prudent of investors.