A policy-driven bond bubble?

In a fairly long post earlier this year, I took a look at bond markets. One thing I thought worth asking was — is there a bubble in fear?

If there is a bond bubble, it’s only got larger since I wrote that post.

But in the spirit of pondering a bond bubbles, three articles in the FT have caught my eye today.

First — Global fund managers warn of bond bubble. Four out of five fund managers (in a survey of 300) think that bonds are currently overvalued. Although a cynic might ask the follow up question — are you still buying them then?

Second — Bond market fears liquidity crunch. This is about fears over crowded trades in emerging market and corporate debt and the fact that bond market liquidity appears to be lower than in previous times. The potential is there for a disorderly move in markets if too many people try to exit these trades at once.

As I noted a couple few weeks ago, this liquidity shortage even extends to the market for US government debt.

Finally — Raise rates or face ‘devasting’ bubbles, says Fed official. The Fed official in question is James Bullard of the St Louis Fed and this headline speaks for itself.

To understand policy makers concerns, we need look no further than the following numbers from the FT:

Of the big groups, Vanguard has more than doubled its mutual fund bond holdings to $497bn today compared with $170bn in 2008, Pimco has increased its mutual fund bond assets under management to $404bn from $210bn and BlackRock’s have risen to $139bn from $26bn, says Morningstar.

The simple facts are that billions of dollars has followed into assets like corporate bonds over the past few years and the price of those assets has risen commensurately. The fear is twofold — that weak liquidity in these markets could lead to a nasty overshoot if they found themselves under pressure and that a Fed rate hike could provide one potential trigger for just such a repricing.

A related issue is that at least some of the rally in equity prices has been driven by corporate bond issuance — faced with cheap credit, firms have issued bonds and used the proceeds to buy back their own stock pushing up prices in that market too.

But on one level I find the public hand-wringing from central bankers slightly disingenuous.

The inflows into assets like corporate bonds and the associated high valuations are a not a bug of policy, they are feature.

One of the mechanisms through which QE (electronically creating money to buy bonds) is supposed to operate is the ‘portfolio rebalancing channel’. The idea that once banks, pension funds or insurance companies have sold their government bonds to the central bank they will reinvest that cash elsewhere.

One of the mechanisms though which low interest rates are supposed to operate is through promoting exactly the kind of ‘search for yield’ in asset markets that has played out over the last few years.

Faced with low returns on government debt, the hope was always that investors would shift resources towards other riskier markets and support economic growth.

Nowadays the hope is that through a combination of old fashioned (conventional and unconventional) monetary policy and the newer tool kit of ‘macroprudential regulation’ (tweaking things like capital requirements and lending criteria to try and contain credit bubbles) central banks can both have their cake and eat it. Achieve low rates to support growth and use macro-prudential tools to prevent bubbles. This what I’ve called a monetary policy which is cheap but not easy.

That’s the theory anyway. We’ll see over the next economic cycle how this works out in practice. But if there is a bubble in bonds, we don’t have to look far to see who inflated it.