A Rant Against the Use of the Word “Bubble” in the Context of the Bond Market

I was reading Duncan Weldon’s very interesting “A Policy Driven Bond Bubble” (see also “Is There a Bubble in Fear” plus “A Monetary Policy Which Is Cheap But Not Easy”), and I found myself thinking:

We should careful when we call things “bubbles”.

When we call something a “bubble” we attach a number of meaning-tags to it. Here are three:

1. Bubbles are collective irrationality.

2. Bubbles pop.

3. Owning bubbly assets entails large long- and fat-tailed risks.

Safe bond prices are certainly elevated — more than elevated: absurd. The Federal Reserve has squeezed the term premium by shrinking the supply of long-term bonds and put the underlying fundamental future short rate to which the term previous applied on a very low path.

But does holding bonds entail accepting large long- and fat-tailed risks? Only if you must sell your bonds in the future. If you have the option to hold them to maturity, your risks are bounded and very small. What you are complaining about is not risk, but rather lousy expected return. And even if you cannot hold them to maturity, the fact that others can hold them to maturity provides a pool of demand that limits how far bond prices can crash.

Must bond prices undergo a sharp drop as interest rates spike? No. It might happen — and it might not. But with a bubble you know there is going to be a crash. With a bubble, the people holding the asset at any moment know that its fundamental value does not match its price. They hope that they will be able to sell their position to a greater fool at a higher price. But nobody in a bubble who understands what is going on thinks holding the asset to maturity or for the long run will end in less than tears.

And are bond prices collective irrationality? Are the traders and investors who are holding bonds making a large collective mistake? I certainly believe most of them should shrink their bond positions and invest in diversified equities instead. But many have: that is why the Shiller stock price to average earnings over the last decade stands at 27.85 — a cyclically-adjusted earnings yield of 4%/year:

But if you are unwilling to accept the equity risk that you could lose 40% of your value in a year — as people did in 2008, 2001, 1974, 1945, 1937, 1929-1933, 1907, and 1904, and almost in 1970 and 1987 — should stock prices return next year to their long-term average earnings yields, your choices are limited. Cash and near-cash are not attractive to anyone save those unable to get the option to hold long Treasuries to maturity. What is “irrational” is not bond traders and investors, but rather the economy that has convinced the Federal Reserve that its current low-rates-forecast-forever policy path is the best it can do.

Thus I think clearer thought is obtained by eschewing applying the word “bubble” the bond market. Call them extremely richly-valued. Call them low return. Call them risky for those without the option to hold them to maturity. But if you have to use the word “bubble” apply it to other things.

I wouldn’t even say that the U.S. is currently in a monetary policy bubble. For that to be the case, it would have to be a small open economy borrowing heavily in foreign currency, or in some form of currency union with larger economic powers…