Another bubble is brewing – bonds [FT]
By Edward Chancellor
Published: January 4 2009 18:27 | Last updated: January 4 2009 18:27
Central bankers around the world have promised to pay more attention to the dangers posed by asset price bubbles. Yet they seem unable to refrain from inflating new ones. The recent surge in the market for US government bonds has several characteristics of a classic bubble.
A bubble is defined by extreme overvaluation. Ten-year Treasuries with yields at half-century lows meet this description. The current yield of little more than 2 per cent provides no protection against the return of inflation any time over the next decade. In normal times, there would be no argument that Treasuries are overpriced. These are not normal times, however.
Another essential attribute of a bubble is that it should be sold with a great story. A decade ago, overblown expectations for internet commerce fuelled the technology boom.
Today’s great hype is deflation. Tales of global recession and collapsing financial markets are embroidered with lurid narratives from the 1930s and Japan in the 1990s. This bubble is motivated by fear rather than greed. Investors are seeking to protect themselves against deflation and declining stock markets by blindly acquiring “risk-free” government bonds.
The behaviour of institutional investors also contributes to the bond bubble. Pension funds, insurers and others have sold off toxic securitised triple-A rated bonds and replaced them with Treasuries. Government bonds are also attractive for diversification purposes since they have held up while just about everything else in their investment portfolios has collapsed. Many of the more sophisticated bond bulls are playing a “greater fool” game. Like dotcom speculators of the late 1990s, they know there is a danger the market will sell off at some time in the future. Nevertheless, they are staying for the ride and hope to bail out before it is too late.
A common feature of great bubbles is that they enjoy the support of the authorities. In 1720, the public acquired shares in the South Sea Company secure in the knowledge that the bubble was promoted by the government of the day.
Today’s bond buyers place their faith in Ben Bernanke. The Fed chairman has long made it clear he sees low long-term rates as a tool for combating deflation. In December, the Fed announced it was considering purchasing government bonds. Just as the “Greenspan put” emboldened stock speculators a decade ago, the “Bernanke put” has placed an apparent floor under the market for Treasuries.
The deflation story that drives the current bond bubble is more plausible than the dotcom pipe-dreams of yesteryear. Deflation is sparked by a combination of bank losses and tighter lending standards, increasing risk aversion and a rise in the demand for money, falling household consumption and higher savings, together with mounting unemployment and a widening output gap. All these conditions pertain today. If this crisis were left to its own devices, the result would likely be a pronounced and prolonged decline in the price level as occurred in the early 1930s.
However, the authorities are not standing by idly. Instead, the Fed is bolstering the credit markets in numerous ways and has cut short-term rates to near zero. Some $7,200bn (£4,930bn, €5,150bn) has been pledged to support the US financial system, of which $2,600bn has already been spent. Although bank lending is currently stagnant, the monetary base climbed by 775 per cent in the year to November.
Broader monetary aggregates are also expanding. The St Louis Fed’s MZM measure climbed 11.2 per cent over the past year. Nor is there evidence of widespread deflation in the economy. Although, the consumer price index has started to fall, only transportation has showed a pronounced decline. There is also the fiscal response to consider. Morgan Stanley projects that in 2009 the gross US fiscal deficit, including asset purchases from the private sector, will exceed 10 per cent of GDP.
Mr Bernanke gained his moniker “Helicopter Ben” after his famous November 2002 speech in which he outlined the various ways by which the authorities could combat deflation. “The US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices of those goods and services,” stated the former Princeton economist and future Fed chairman.
“We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Investors who purchase long-dated Treasuries at current prices are betting that a determined man with the dollar printing press will fail in his battle against deflation.
Edward Chancellor is a member of GMO’s asset allocation team |
