Market Views

Joe Zidle: The Last Stage of a Bubble is Acceptance

Tulip bulbs, the Dutch East India Trading Company, Japanese real estate, tech stocks, US housing—what these disparate assets have in common is a history of bubbles. Sovereign bonds are set to join that list soon as their bubble nears its end. Last week’s intra-day inversion of the 10Y/2Y Treasury spread signals that yields could go a little lower, though a move much higher is possible. A year ago, the 10-year US Treasury yielded 3.2% and essentially only Japanese bonds yielded less than zero. Today, negative-yielding bonds total over $16 trillion globally, with issuers ranging from Austria to Slovenia.(1) Despite negative rates, massive inflows continue.

Denial ain’t just a river in Egypt

 In 1999, tech stocks defied all logic and valuations. Champions of the frenzy denied fundamental measures of value, calling it a “new paradigm.” In 2007, housing bulls pushed home prices sky-high, arguing that “housing prices never go down.” And at the height of the 17th-century Tulip Mania, one scholar claims that a single tulip bulb would have fetched enough to “purchase one of the grandest homes on the most fashionable canal in Amsterdam.”(2) Today, justification for this sovereign debt bubble includes arguments like “negative rates are normal.” If there was any doubt, one sure sign of a bubble is when people stop questioning whether it’s a bubble.  

Investors are playing hot potato

 At negative yields, assets perceived to be the safest in the world may actually be among the riskiest. Greece has spent roughly half of its time as a sovereign nation in default, yet today Greek 10-year bonds yield about the same as US Treasuries.(3) Greek bonds are but one example of asymmetric risk. Investors can lose three different ways when investing at a negative yield: 1) lost principal when the investment is held to maturity, 2) less purchasing power due to the effects of inflation and 3) opportunity costs relative to an investment returns more than zero over, say, 30 years (compared to a 30-year German Bund at -0.22%).(4)

The contagion effect is real

 When tech stocks deflated, a recession soon followed. The popping of the housing bubble caused the deepest recession since the Great Depression. We can’t say for certain what will cause conditions to change, but the chart below illustrates the risk. It shows a security whose price has doubled in the past two years, and it’s not a high-flying tech disruptor or a non-meat burger company. Rather, it’s the price return of the 100-year Austrian government bond. Such speculation is not normal, and the slightest backup in rates will likely cause the speculative inflows to quickly reverse. Algorithmic trading and passive ETF outflows could magnify downward bond movements. Once a moderating force for price swings, financial firms no longer hold bonds.

Austrian 100-Year Government Bond Price(5)

Seek alternative routes for protection

With the proliferation of negative and low rates, investors are extending out duration in order to capture yield. We would actually shorten durations, reduce sovereign weights to zero and seek out non-traditional bonds that have the ability to adjust to higher rates. Cash and cash alternatives should be considered as well.

1. Source: Bloomberg Barclays Global Aggregate Negative-Yielding Debt Index, as of 8/16/19.

2. Sooke, Alastair. “Tulip Mania: The Flowers That Cost More than Houses.” BBC, May 3, 2016.

3. Reinhart, Carmen M., and Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2009.

4. Source: Bloomberg as of 8/16/19.

5. Source: Bloomberg, as of 8/16/19.

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