The United States Treasury bond bubble that we started writing about in May 2012 is still here and has been recently making headlines. Our thesis since 2012 has been that any reset higher in US real growth or inflation rates would begin a reversal of the thirty year bond bull market and result in bond prices declining 30- 50% as interest rates normalize higher. This target was not so much a guess as it was simple bond math.
Bond yields are as low as they ever get and bond prices, which move inversely to rates, are as high as they ever get. Bond prices could move even higher if we move into a serious economic contraction and deflation as Japan did in the late 1990s. The 10 year Japanese government bond yield fell below 2% back in 1998 and has remained there ever since because Japanese economic policy has failed to inspire real growth. The Japanese bond market bubble is over a decade old and has not popped.
A Japanese scenario for the US economy seems unlikely. The US dollar has been strong and strengthening since late 2012 while the fiscal and regulatory policy landscape has been transitioning away from anti-growth policies since the 2010 midterm elections.
Importantly, government economic policy sets asset prices. Policy has the power to make and pop bubbles. Despite what popular financial press likes to report, markets are not “things” that are inherently overvalued, oversold or in a “bubble.” Markets are merely clearing mechanisms that bring together buyers and sellers at a price. That price itself can never be wrong, but the buyer or seller transacting at that price can be. Markets do not “top” and bubbles do not “pop” because prices are high. They top and pop when government economic policy shifts change the landscape for capital flows. Jude Wanniski provides excellent and rarely discussed policy based causes for major turning points in US markets. His most famous policy based view is that the Smoot-Hawley tariff legislation coincided day-to-day with the Wall Street stock market Crash of 1929,and the Great Depression was the result of the Smoot-Hawley tariff. More modern policy based turning points include:
- President Johnson’s 1967 destructive income tax hikes to pay for Vietnam War that send capital fleeing the US for Europe
- President Nixon’s 1971 abandonment of the US dollar-gold link that sent the world into floating rate currency system and crushed the value of the US$
- President Reagan’s tax cuts and sound US$ monetary policy that set of the boom years of the 1980s.
Much can be revealed using a policy based lens to view current markets. US stocks are not overvalued, expensive or dangerous to own unless and until an anti-growth economic policy mistake is made. The US bond bubble will not pop until a pro-growth economic policy agenda is fully embraced that lifts real growth rates.
The good news is that policy is trending towards growth and market “Footprints” of policy have been picking up on this change. US stocks continue to make new nominal highs, and since gold prices remain depressed (US$ remains strong) the market is also gaining ground in real terms. Bond prices, which had been strong in 2014 and early 2015, have recently reversed lowed. US Treasury bonds have already fallen 15% since February, and as the long bond ETF chart below shows, they have much further to fall to return to levels of recent years.
Rising US equity prices and a strong US$ (falling gold price) have been confirming better US growth policies ahead, and a rising growth economy will lift real US interest rates. Avoid bonds as interest rates increase. If one must own bonds, then duration should be short. Remember, nominal bond yields are the sum of a real interest rate plus an expected inflation rate. Every second that the bond market is open investors decides the balance of real growth and inflation. As the chart below shows, inflation expectations have been well behaved since 2009 and have been falling below 2% recently. The problem hasn’t been inflation. The problem has been an abysmally low real growth rate component. Just last month the real rate deteriorated to 0%, meaning that the bond market basically saw zero growth for the US economy over the next ten years. The good news is the real rate recently spiked higher to 0.55% sending bond prices down to new lows.
As economic policy improves this will be just the beginning of real rates returning to more normal levels well above 2%. As real growth improvements push nominal rates higher, the bond bubble will continue popping and US equity prices will continue rising. Markets are increasingly revealing that the country will finally get what it deserve – a return to 1980s/90s style prosperity.
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