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Sunday, August 29, 2010

The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.
The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

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