Talking Point: Bond bubbles, Bernanke and the Baby Boom

There is no question that interest rates are low. Treasury yields have been in a secular decline for the last 30 years and there is simply little room to fall further.

Real yields – that is yields adjusted for inflation – are also low, though not to the same magnitude as nominal yields.

So lower actual inflation combined with a shrinking uncertainty premium as the collective memory of inflation fades, have both been at least partially responsible for allowing long term yields to decline. However, the real concern today is that the zero-percent monetary policy currently being pursued by the Fed is far looser than any other period in the last 30 years and has created so much liquidity that inflation is sure to occur, and this will eventually erode the principal value of longer maturity bonds. Though the Federal funds rate cannot decline further from here the Fed’s signal that it may hold this policy unchanged well into 2011, combined with additional purchases of fixed income securities, is sowing the seeds of future inflation.

Bernanke
This last bit is important. Monetary policy this loose is to fight the risk of a debilitating, Japan-like deflation. Prior to becoming Fed Chairman, Ben Bernanke proposed that aggressive rate cutting and quantitative easing – security purchases by the Fed – would lead to rapid money creation and easier lending terms that could more than offset deflationary pressures. In short, the Fed will print enough dollars to spark inflation, erring on the side of creating higher inflation which it knows how to fight, rather than risk outright price declines where deflation-fighting policies are uncertain. The Federal Reserve has never confronted deflation in the modern financial era, and this marks a massive shift in direction from the Fed’s main concern over the last three decades. Bonds have benefited from the Fed’s inflation-fighting credentials established since 1980, so its efforts to create inflation are understandably scaring bond investors. During the last two years the official Fed funds rate has been brushing zero percent and the Fed has purchased over $1.7 trillion dollars worth of mortgage-backed securities, Treasuries, and agency notes in order to help lower long term borrowing costs. Zero percent cash yields have forced many investors to buy longer bonds to find higher yield and, with long-term interest rates already painfully low, the Fed is considering another round of security purchases. It’s been a perfect storm for yields to fall….

But is the bond market in a bubble? We don’t believe it is. There are two factors to consider. Firstly, the real Fed funds rate is negative and we do believe this will be inflationary. Eventually. Secondly – and more important – is to assess where that inflation occurs. Consumer prices don’t capture the full impact of easy monetary policy. Inflation may be beginning in an unexpected part of the economy, and we think we know where it is…

Baby Boom
Why bring demographics into our discussion of the bond market? Because the baby boom is still the dominant trend in the US and we believe it is influencing how excessively loose Fed policy impacts certain asset prices. When money is cheap, like it is now, inflation will occur. It’s just a matter of time – usually with significant lags – as well as a matter of where: what goods are pursued with the cheap money. Inflation can take many different forms and will appear predominantly in the economic sector that is in demand the most. In the last four decades, the ‘in demand’ sector has been determined by demographics – the baby boom.

There have been four periods of very easy money since 1970, using the real Fed funds rate (Fed funds rate minus core inflation) as a simple measure of monetary conditions. These are shown in the chart below, followed by a chart showing the average age of the baby boomers. While inflation as measured by consumer prices accelerated only after the easy money of the 1970s, prices in other areas rose after each of the other periods of negative Fed funds rates. The price increases are consistent with where the Boomer generation was spending, or investing.

These connections make sense. In each case the Boomer’s collective buying power overwhelmed existing supply. Moreover, rising prices attracted additional investment, intensifying price increases, leading to speculation and eventually the bubbles in equities in the 1990s and home prices in the last decade.
There are, of course, other factors in play. OPEC and ill-conceived price controls contributed to goods inflation in the ‘70s, while gross relaxation of lending policies helped fuel the recent housing bubble.
Now, as the Boomer generation approaches retirement, investment preferences are shifting to income and stability (especially after the volatility of the dot.com and housing bubbles) and the bond market is benefitting, even as total Treasury supply also accelerates. Cyclical forces will normally dominate other factors, however the collective force of the Boomer investment can keep yields lower for longer than might otherwise be the case.So are bonds in a bubble?

Boomers, bubbles and Bernanke
Bond yields are low by nearly every measure. But they are likely to remain low for the foreseeable future. Demographically-driven shifts in investment often take many years to play out, and we believe we are still in the early phases of Boomers’ portfolio repositioning. Moreover, the backdrop continues to be very supportive of low bond yields: (1) unemployment remains very high which will hold down wage pressures; (2) there is substantial slack in manufacturing capacity suggesting inflation is still a long way off; (3) low cash yields are compelling investors into longer maturity investments in order to increase yield; and (4) economic uncertainty is keeping investors wary of equities or other growth vehicles. Also, the high amounts of leverage built up during the housing boom are still being brought down, a process that will restrain growth and which is itself deflationary. Bernanke and the Fed are succeeding in creating inflation – although not where most investors expected. Their efforts to lower borrowing costs and head off deflation coincides with rapidly rising demand for fixed income within Boomer investment portfolios as well as larger pension plans which are planning for their retirement. Both the deflationary economic backdrop and the preference for liquid, less volatile investments are likely to be in place for quite some time, suggesting that bonds yields remain lower for longer than most investors have forecast. The chasing of higher bond prices may eventually turn speculative and lead to a bubble in bonds.
There will come a time when the US economy is growing more rapidly and wage pressures begin to mount, when delevering has run its course and liquidity is again being recycled, and when retirees begin to sell fixed income holdings to finance spending. However, these factors are a long way from being a threat to low interest rates. Investors must also contend with a combination of weak economic trends, the deflationary impact of debt reductions and demographics – all of which will hold down interest rates for the foreseeable future. In this context, record low bond yields make plenty of sense.