Credit: Shutterstock photoA financial bubble occurs when the price of a security rises beyond its value defined by its fundamentals. The trend typically continues to the point where the long term benefit of ownership no longer outweighs the cost of investing, resulting in a sharp decline. The dot.com and 2008 Financial Crisis both originated by bubbles that grew so large that they eventually popped. Today the biggest bubble isn’t forming in the equities market, but in the bond market.
Just like equities, bonds are frighteningly overvalued. Yields are hovering around historic lows while prices continue to skyrocket. Conventional wisdom has it that this inverse relationship should stop funds from investing in bonds, but that hasn’t been the case. Investors, now more than ever, are parking themselves in government bonds because they are still being viewed as a safe haven.
Around the world government bonds yielding negative returns have reached $11.7 trillion, a $1.3 trillion increase since the end of May, according to Fitch ratings. A large portion of this comes on the back of low rates and asset purchases by the European Central Bank, Bank of Japan and Bank of England. In fact, the Bank of England recently cut rates and restarted quantitative easing to support the economy in the wake of Brexit.
Meanwhile, the Fed has predictably decided to leave interest rates unchanged, presumably until December. Lately the Bank of Japan seems to be the only one making progress to normalization. The central bank recently announced they would start targeting yields on the 10-year government bonds near zero percent, well above the current rate of -0.079. This closes the door, for the time being, on a historic bond market collapse starting in Tokyo, but that doesn’t mean it can’t start elsewhere.
Central bank efforts to keep rates near or below zero have created near term headwinds for the market. This means investors who purchase government bonds and hold them to maturity will end up losing money excluding the cost of inflation. The consensus is that it is doing more harm than good, but that hasn’t stopped investors.
Bond prices continue to climb while yields decrease, making the cost even more expensive. The record demand for these assets have been driven by the perceived notion of security rather value. Irrational exuberance, like we are seeing here, is often a predecessor to a significant downturn or even crash.
Unfortunately, we can’t rule out even further declines in yield. Persistently low growth and inflation stemming from years of macroeconomic volatility could provoke more bond buying in the near future. If this is the case, don’t expect all investors to sit quietly. Many investors have already fled to riskier assets in the equity market to compensate for lower yields. This perpetuates another problem on whether or not the stock market is overvalued.
Eventually the bond bubble can end one of two ways: it can deflate naturally or it can burst. If interest rates are to increase too quickly, we are more likely to see the bond bubble pop. Prices will decline and yields will increase drastically, causing a massive sell off in interest sensitive securities. Bond holders from this historically low yield period will no longer be incentivized to hold their depreciating assets. Furthermore, sectors that thrived in the low rate environment, such as dividend stocks, REITs, and utilities, will begin to face significant headwinds.
To be fair, central banks have been prudent when it comes to interest rates. They are waiting for a modest rise in inflation and a pick-up in economic growth before they begin the normalization process. There is already some evidence, at least in the U.S., that these two indicators are headed in the right direction.
In other words, a Fed hike at December’s FOMC meeting shouldn’t stir up significant volatility or shake the market. Bond yields aren’t likely headed much lower or higher than where they are now, meaning a near time bond market collapse is improbable.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
