The Fundamentals Of The Bond ‘Bubble’

They were never very specific to begin with, even in Ben Bernanke’s infamous November 2010 Post op-ed covering the start of QE2. Officials like to keep it purposefully vague as a kind of dry powder, a margin for error. If bureaucrats become too specific, the public would reasonably hold them to their own standard being laid out. The point behind Alan Greenspan’s infamous fedspeak was, most of all, wiggle room.

QE is going to help boost the economy. How you naturally ask? Don’t say. Keep it ambiguous. At most point to the “financial system” and claim “accommodation” will make things “loose” and “easier.” None of those terms, you’ll notice, really answer your question.

How, exactly, do these things work?

More than a decade of this in the Western world, there’s only more of it on the horizon. In Britain, Silvana Tenreyro, an outside member of the Bank of England’s Monetary Policy Committee, endorsed negative interest rates (NIRP) just yesterday. Giving a speech at a seminar in Bristol, Tenreyo said studies show NIRP has “worked effectively” while “some of the evidence point[s] to more powerful effects.”

This view is supported, according to the BOE, by “strong evidence of transmission into looser bank lending conditions.”

What’s omitted from these situations is the only thing that matters. Monetary authorities worldwide should have made this incredibly simple: we do QE, full recovery follows. End of story. Happy ending, no less.

Instead, this is what central bankers time and again hint at and then watch helplessly as the economy always falls short. In the meantime, interest rates – over time – only fall, too, because…

Why do they decline, exactly? If they do, why don’t they ever seem to come back up apart from small, temporary bursts?

According to the same nebulous doctrine utilized in the conventional narrative, interest rates follow along with whatever central bankers are doing; even if no one really knows what that is. Either way, low rates are “stimulus” in the Economics textbook, and no monetary authority will deny themselves the chance at such an easy if incorrect correlation.

Since this intellectual vacuum has continued unchallenged for such a long time without needed correction (derived from an honest analysis of the evidence itself), it has led to a pretty widely held idea that bonds, in particular, have experienced an unnecessary and unhealthy “bull” market to the proportions of being in a bubble. A bond bubble.

From this perch, all the Bond Kings.

What is a bond bubble, anyway? Employing that specific term can only lead to a specific meaning. And that is any asset class or market which must be experiencing some kind of price imbalance beyond all reasonable thresholds. The stock market of the dot-com era provides a recent and near-perfect example easily understood by everyone. Prices that outrun all fundamental prospects and reductions into rational valuations.

Given this, it may not be perfectly clear what that could mean insofar as bonds are concerned. Fundamentals and price imbalances, all most of the public really believes is that interest rates are low because central bankers and the media (same thing) have said they want rates that way. Officials seem to even want them to be negative, claiming it helpful (without being too precise about how).

The fundamentals for bonds – really meaning safe and highly liquid instruments, such as sovereign issues of the highest quality – are simply whatever factors that highlight these underlying characteristics. In terms of any potential bubble, whatever conditions when the safest and most liquid instruments could be priced at enormous premiums when there doesn’t seem to be any rational reason for them to have achieved such (extreme) over-valuation.

We know without a doubt from historical examples what those look like; when times are good, or inflationary, there’s no fundamental reason to overpay for safe and liquid. During heightened inflationary conditions, even less so. Fundamentally, over the intermediate and long run, the idea of a bond bubble is just that straightforward.

And let’s use one prime historical example: Japan.

This one is also incredibly easy to understand, requiring no Fedspeak to color or off-color what is otherwise perfectly candid, rational analysis; and this is why you don’t hear much about what’s been going on in Japan for such a very long time.

Time appears to play a huge role in this element of confusion. There is an idea that fundamental conditions like growth and inflation cannot remain undesirable for prolonged stretches (no unit-roots or permanent shocks are allowed in econometrics; whether econometrics is an accurate depiction of reality is really the question); therefore, it is merely assumed, if bond yields remain low (meaning prices high) for a very long time it must be due to some artificial intervention or intrusion which has created a bubble that must necessarily end badly at some point.

Not just a BOND ROUT!!!! or even an actual bond rout, a true massacre.

The Japanese example, on the other hand, neatly dispels this very notion. Start with Japan’s economic condition (note: Japanese economic statistics were reworked in 2000-01, meaning that older GDE figures aren’t directly comparable to the modern GDP estimates consistent with the way data is calculated around the rest of the world; for our purposes here, they are certainly within a reasonable range).

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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