Anyone Who Says That Bonds Are In A Bubble Needs To Answer Two Simple Questions

Wikimedia CommonsWith markets hitting new highs, the “b-word” has been getting tossed around a lot more.

It’s being applied to both stocks and bonds equally. And there’s a large contingent of people hate bonds, and think the bond market is a bubble being engineered by Bernanke.

But as Paul Krugman has recently pointed out, there’s a big flaw with saying bonds are in a bubble.

…the interest rate on long-term bonds depends mainly on the expected path of short-term interest rates, which are controlled by the Federal Reserve. You don’t want to buy a 10-year bond at less than 2 per cent, the current going rate, if you believe that the Fed will be raising short-term rates to 4 per cent or 5 per cent in the not-too-distant future.

But why, exactly, should you believe any such thing? The Fed normally cuts rates when unemployment is high and inflation is low — which is the situation today. True, it can’t cut rates any further because they’re already near zero and can’t go lower. (Otherwise investors would just sit on cash.) But it’s hard to see why the Fed should raise rates until unemployment falls a lot and/or inflation surges, and there’s no hint in the data that anything like that is going to happen for years to come.

So long-term rates are mostly the function of the expected path of short-term interest rates.

And right now the Fed is missing its target on both unemployment and inflation (which is below target and fading). So the question is: Why would the Fed be raising rates now, or any time in the near future? And given the miss on the dual mandate, what should short term rates be?

If you think bonds are in a bubble, then you should have answers to those questions.

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