Bond Bubble – I’m not afraid to call it

By ,   March 3, 2015

Avatar of

Economic numbers throughout the U.S. show a strong economy.  Manufacturing, labor, utilization, etc. all point to a solid recovery.  Wage inflation has been the last stagnant number, but even it is showing some improvement as the labor market continues to tighten.  However, “the market” continues to discount the strength evidenced by historically low yields on Treasury bonds.  Even the Fed, headed by the dovish Janet Yellen, has higher expectations for yields than are currently being priced in.  There is plenty of debate for the cause, but the bottom line is that there is a disconnect between market expectations and fundamentals; and when you have disconnections, prices can react sharply when the market finally starts paying attention to the data.  

Throughout history, we’ve had numerous events that have caused market prices to disconnect from fundamental data.  Let’s not even get started on the so called “Efficient Market Hypothesis”, it’s simply intuitive that there is a behavioral element to investing, and when emotions get out of control – price bubbles happen.  The Tech Bubble, the Housing Bubble, the Great Tulip Bubble of 1637…history is filled with examples, and I think we are approaching a similar situation with the bond market.  

In J.P. Morgan’s Guide to the Markets, there is a great chart of Fed expectations for the future Fed Funds rate and what the market is expecting…

Fed Funds Rate Expectations

JP Morgan: Guide to the Markets – U.S. Data are as of 12/31/14  Market expectations are the federal funds rates priced into the fed futures market.

The Federal Reserve has already been criticized for over a year by many (outside and inside the Fed) as being behind the curve, suggesting they should have already raised rates with the improvement in the economy.  With market expectations even lower than Fed estimates, it suggests a widening margin between where prices are and where they “should be”.  As with any bubble, there is usually a fulcrum, and once it is tipped, a sharp repricing follows.  

St. Louis Fed President James Bullard warned of this very event in a recent interview and has been an advocate for a faster rate hike schedule to try and prevent a bubble from developing.  I agree with Bullard, but the market isn’t listening.  When the market finally does start paying attention to the data, we may be in for a wild ride in the bond market.  

Spicer, Jonathan – “Interview: Fed’s Bullard warns over sharp ‘wake up’ call in markets” – Thomson Reuters