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Friday, June 4, 2010

Weekend Reading: Bonds a Bubble?

There has been a fairly consistent refrain for two years or even longer that treasuries may indeed be overpriced, meaning that interest rates are consequently too low on long term instruments. This interesting article from MarketWatch hits on this idea yet again.

One thing worth considering is what it would mean if the long term treasury market actually did go bust. What are the implications for your investments? Unfortunately, this is not a pleasant prospect and it leads to one wondering where exactly their money should go. I actually don't have any particularly firm answers on this front, to be quite honest, but maybe by talking it through we can uncover some possibilities.

So, let's just say for a moment that for one reason or another, long term bond prices suddenly collapse. This could be because of worries about the solvency of the U.S., suddenly higher inflation expectations, or much more attractive investments elsewhere. The last two are more like than the first. Basically, if investors either need to abandon the safety of treasuries to beat inflation or if they feel that other markets offer stable enough returns that they can leave their fortress of U.S. treasuries, bonds will rout. How vulnerable are bond prices to changes in long term interest rates? Well, if rates on the 10-year rose from 3.30% to 5.00%, a $1,000 investment in treasuries would turn into $866.86. Ouch.

However, the nasty effect is not just felt there. Corporate bonds would similar be whacked be a sudden "pop" of the bond market. Even if rate spreads remained constant, you would see a similar rout in corporate bonds. Stocks would face an interesting whiplash effect where money seeking higher rates of return would first flow into stocks and then back into bonds as interest rates rose, making bonds more attractive. That process would repeat several times before the markets found equilibrium. This would be particularly true if there was a panic in the bond market. If it was a longer adjustment period, which is what most talk about, stocks would probably forgo dramatic movement. If, on the other hand, treasuries collapsed in true bubble fashion and were obliterated in a, say, six-week period, this could get messy. In fact, in the event of a true rout in bonds where prices start falling almost arbitrarily fast, stocks would probably fall faster due to the disruption to credit markets.

How likely is a truly ugly collapse in treasuries? Not very. I do think there is a "safety premium" that people have given treasuries given all of the mess in the world the last few years and once again right now for much the same reasons. However, at some point this will diminish as relative rates of return have to move closer to equilibrium, though they rarely stay there, which is why you can make money on market inefficiencies. I think up to a 10% hair cut on long bonds is very possible over the next 18 months assuming that the European crisis doesn't turn into a full-blown relapse of 2008.

In short, this is all speculation and none of this may come to pass, but it is worth considering. I think this may be one of the few circumstances where gold would actually look good to me, though at some point I hope to discuss how the price of gold correlates to very little at all over time.

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