Economist Martin Feldstein has a piece up a Project Syndicate saying that interest rates are unsustainably low, and that there’s a bubble just waiting to be burst in the fixed income world.
Over the last few years, there’s been a ton of folks saying Treasuries are in a bubble and throughout this time, bonds have mostly rallied further, causing bond bears to tear their hair out in frustration.
Advocates of the idea that there’s a bond bubble idea usually blame Quantiative Easing (Fed bond buying). Or they say that the US is a rare safe haven, benefiting from the crises abroad, and that as soon as those crises abate, the bid will evaporate.
Anyway, without making a call on which way interest rates will go, it’s fairly easy to show that Treasuries are not in a bubble.
Back in early March, Ben Bernanke gave a great speech on what’s driving rates, and he showed this chart, which decomposes the factors that drive interest rates.
There are three primary drivers:
- Expected inflation.
- Expectations of future short-term interest rates (which are driven by Fed policy).
- And the term premium, which represents how much extra compensation investors demand to buy long-term debt.
As you can see, over the last decade or so, there’s been a really big decline in the expected path of short-term interest rates (understandably, since the Fed has indicated low rates for a long time). And there’s been a very steady drift in inflation expectations. And there’s been a big drop in the term premium. In fact, the term premium has gone negative, which means that rather than demanding extra compensation for long-term debt, people are actually willing to pay a premium for it.
On this last point, the negative term premium is what people see as evidence of a bubble fuelled by the Fed. But that’s not it.
In a great post responding to Bernanke last month, economist David Beckworth explained why the term premium is negative, and why it’s not about QE (which contrary to belief haven’t been very big purchases):
On the later, Bernanke attributes the term premium’s decline to three things: increased interest rate certainty because of the zero lower bound (makes it easier to forecast), the safe asset shortage problem, and the Fed’s large scale asset purchases (LSAPs). The first two of these developments are result of the crisis. Only the LSAPs are the Fed’s doing. So most of the factors driving down the 10-year treasury yields have been developments outside the Fed. This is consistent with the pattern of safe asset yields falling across the world. It is hard to find support for the FGE view here.
There is more Bernanke could have said about the LSAPs. First, contrary to the claims of many FGE proponents, the LSAPs have not been terribly large in relative terms. The stock of marketable treasuries went from about $5.13 trillion at the end of 2007 to $11.27 trillion at the end of 2012. Over this same time, the Fed’s holding started near $0.74 trillion and reached $1.65 trillion. The Fed’s net gains, then, are approximately $0.94 trillion over this time compared to $6.14 trillion change in marketable debt. (The Fed actually has purchased a little more, but it also sold some securities in 2007.)
Bottom line: Inflation is expected to be tame. The Fed is expected to be on hold for a long time. And thanks to hedging needs and rate certainty and a partly QE, the term premium has gone negative.
Underlying conditions could change. But given current conditions, Treasuries are properly valued and not in a bubble.