Dear Mr. Greenspan: A Bond Bubble? Really? - Context
by Fixed Income AllianceBernstein
Reading the signs in markets can be tough. When he headed the Federal Reserve, Alan Greenspan missed early signs of a housing bubble. Now he’s warning of a bond bubble that’s about to burst. We disagree.
We certainly agree with Greenspan that the 30-year bull run in bonds is over and that interest rates will rise. But we don’t share his belief that Fed tightening will cause long-term rates to rise rapidly, provoking a bond market collapse.
First, it’s important to get our definitions straight. To us, a bubble exists when investors are ignoring valuations and buying assets simply because they think they’ll get rich by selling the assets to another buyer at a higher price.
That doesn’t sound like today’s market. Investors aren’t buying five-year US Treasury notes, which yield about 1.75%, as a get-rich-quick scheme. The five-year forward rate for this asset implies a 2.7% yield in 2022. That’s a pretty gradual increase, and well within the range of what a rational investor might expect today given global central bank policy and inflation expectations for the next few years.
And Treasuries are usually the first asset to “clear” when changing interest-rate cycles create volatility. For example, let’s assume that today’s forward curve is correct and that the five-year Treasury will, in five years’ time, carry a yield close to 3%. This will almost certainly attract new buyers.
Two decades ago, Greenspan famously warned investors about “irrational exuberance” in financial markets. But irrational exuberance doesn’t really apply to the market for risk-mitigating assets like Treasuries.
SLOW AND STEADY
It’s true that central banks will be entering unchartered territory as they begin to withdraw the massive stimulus that bolstered markets and the real economy after the global financial crisis. The Fed is likely to start shrinking its $4.5 trillion balance sheet before the year is out, while the European Central Bank may slow its bond purchases this year and possibly start reducing its own balance sheet in 2018.
All this stimulus has had a huge effect on financial assets, so it’s reasonable to expect some volatility. The good news, though, is that we expect central banks to withdraw stimulus gradually. The Fed has in some sense set the pace with its current interest-rate cycle. Over 18 months, it’s lifted rates just four times.
HIGHER INTEREST RATES = HIGHER POTENTIAL RETURNS
Tighter monetary conditions and rising rates worry bond investors, but they shouldn’t. Will rising rates push up yields? Most likely. But that sets the stage for higher returns, since a bond’s yield is the best indication of what future returns will be.
In fact, over any reasonable time period—let’s say three to five years—the yield on a bond at the time of purchase makes up nearly the entire return profile. In other words, the income that bonds produce accounts for most of the total return. This simple math works both for risk-mitigating assets such as Treasuries and for return-seeking bonds such as high-yield corporates.
This helps explain why most types of bonds did well during the Fed’s last gradual tightening cycle between 2004 and 2006 (Display).
AS THE CURVE FLATTENS, LEAN TOWARD TREASURIES