Bond Bubble

“It is the beginning of the end of the bond market rally. We are done,” said David Tepper the founder of 20 billion USD hedge fund Appaloosa Management. The multi billion dollar hedge fund manager made these comments following the European Central Banks (ECB) most recent interest rate cut. Yields on US bonds kicked off the year in 2014 at around 3 percent, eight months later yields on the ten-year fell to less than 2.4 percent and they are currently trading slightly above that today at 2.45 percent. 

Moreover, in the eurozone bonds have also been rallying this summer, with the yield on 10-year German bonds falling below a measly 1 percent. Just knowing where to invest funds and get a decent return without shouldering excessive risks is getting trickier.

If the US bond market tops out this year it will mark the end of a thirty-year secular bull market that investors have enjoyed since the U.S. 10-year topped out above 15% in the early 1980s. Jeff Gundlach of DoubleLine Funds was one of the few people on Wall Street who predicted this year's rally in bonds and he expects the 10-year yield to remain between 2.2 percent and 2.8 percent, with a downside risk that yields could fall below 2.2 percent. 

At the most influential investor summit in New York, some of the world’s most successful investors debated the state of the global economy. While there were varying views concerning the sustainability of the gloabal economic recovery, there was a unanimous consensus that the bond market has gotten out of control. Moreover, perhaps investors have even become complacent about risks in the bond market.

“Bonds are at ridiculous levels,” said Tiger Management founder Julian Robertson at the Bloomberg summit. “It’s a worldwide phenomenon that governments are buying bonds to keep their countries moving along economically.” There may be two factors in the equation that have caused an unprecedented bond bubble. The extended period of low interest rates coordinated by central banks around the world through quantitative easing,which involved the purchasing of bonds, has been a major factor in fuelling the bond rally and suppressing bond yields.

Additionally, the historic long period of low interest rates may have aided and abetted higher risk taking behaviour by investors. In a period of low interest rates even conservative investors might have been forced out of the safety of low interest rate deposit accounts and tempted to invest in bonds. So there’s been bond buying from governments and central banks around the world with the aim of pumping liquidity into the system following the financial crisis of 2008. Investors were also moving into bonds, as they were perceived to be a less risky asset class than equities. Consequently, the jumped up demand in bonds fuelled a bond price bubble and sent yields crashing down.

But a safe haven asset might not be that safe, particularly for those investors jumping on the bandwagon at the later stage of a rally. Last year the worst performing assets were the so called safe-havens, such as gold, silver and bonds, the latter of which, considered to be a safe-haven asset, fell in value by 13 percent. Gold was also down in 2013 by around 30 percent. The central bank induced rally, spurred on by loose monetary policy, caused a flight of capital from safe-haven assets into equities. Indeed cyclical stocks, which tend to perform well when investors perceive an upturn in the business cycle, were the best performing assets last year.

But a year for traders, or short term investors is a long time. The economic recovery is looking shaky, the eurozone “recovery” is done. China's growth is slowing and Japan is back in negative growth. The UK recovery is weak and unbalanced. The US economy remains a bright spot, but how long can it keep revving with its trading partners remaining in an economic quagmire? Additionally, old risks remain in the market and new ones have emerged. The geopolitical situation has deteriorated, with the Ukraine crisis and tit of tat Russian sanctions. The era of cheap money, which may have just delayed the inevitable, has created new asset bubbles, in equities, bonds, real estate, antiques and maybe even classic cars.

There is no elegant way to burst a bubble. So what is going to happen when the next big debt bubble bursts? A growing number of insiders believe that the current bond bubble is going to end badly with the implications being anything from bad to catastrophic. That translates to mean that national governments can't run their economies in the long term on debt. It may keep the system ticking over for a lengthy period and everything may appear fine but eventually it could collapse in a matter of hours.

Omega Advisors founder Leon Cooperman, thinks the stock market is fully valued but not overheating, called bonds “very overvalued” and Oaktree Capital Group chairman Howard Marks warned investors to “clip the top of the cycle” so that they don’t get caught in the next correction.