Wells Fargo’s James Kochan asks: Is there a bubble in bonds?
James Kochan, investment strategist with Wells Fargo Asset Management, looks at the potential pitfalls of a US bond market that has trended higher over three decades.
For three decades, US bond prices have trended higher, and yields in several sectors are currently the lowest on record, causing some observers to suggest that the bond market might be the “asset bubble” of this cycle.
That is a serious allegation as the word “bubble” conjures up images of huge potential losses, such as the tech-stock bubble burst in 2000 when losses were as great as 90%, and the real estate bubble in 2008 when home values declined by 50% or more in some areas of the United States.
Bubble enthusiasts like to speculate what would happen to bond values if there were a repeat of the prolonged bear market of the 1970s and early 1980s. In that cycle, the yield on the 10-year Treasury note peaked at around 15% in 1981. If that level was realised again in the next five years, the price of the current 10-year note would drop from around 101 to around 55, almost a 50% drop in principal value. That would rank with past bubble disasters.
However, a long list of fundamentals suggests that nothing close to that scenario is likely over the foreseeable future. During the 1970s, the rate of inflation in the US, as measured by the consumer price index (CPI), rose from 3% in 1971 to 13% in 1981. Over that period, the price of crude oil increased from $2 to almost $40 per barrel, unit labour costs were increasing at close to double-digit rates, the money supply was growing at rates as high as 15% per year, and nominal gross domestic product (GDP) growth was at a 20% annual rate in 1980.
Today, oil prices, while high, are not accelerating as they were in the 1970s and unit labour costs are no higher than they were in 2008. The CPI is rising at around a 2% pace, money supply growth is around 4%, and the growth rate of nominal GDP is around 3.5%. Perhaps most importantly, US companies face international competition from low-cost producers that did not exist in the 1970s, preventing them from raising prices and forcing them to control costs.
Another key difference between now and the 1970s is the nature of this business cycle. This recovery fits the historical pattern of very weak recoveries following a severe financial crisis. It typically takes as long as a decade before economic growth returns to a healthy pace after a financial crisis such as we saw in 2008-2009. The failure of the housing sector to recover is one such factor. Because the housing sector is a big user of borrowed money, this ongoing weakness is a key reason why interest rates have stayed low for such an extended period. Even the most optimistic forecasts call for only a slow housing recovery, and that would keep the demand for mortgage credit relatively soft in the years ahead.