During the recent market tumult, bond yields have once again dropped sharply to very low levels, as seen by the yield on the 10-Year Treasury.  A couple of charts illustrate this.  First, a weekly long-term chart from 1962 as seen in Doug Short’s August 12 blog post titled “Treasury Yields in Perspective“, with 10-Year Treasury Yields shown in blue:

(click on chart to enlarge image)

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Next, a 3-year daily chart of the 10-Year Treasury Yield:

(click on chart to enlarge image)(chart courtesy of StockCharts.com)

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While this Bond Bubble may have a little more “upside” left to it, I am of the belief that attempting to derive gains from bonds at this point is akin to “picking up pennies in front of a steamroller” – i.e. there is little to be gained, and much to be lost.

While the Bond Bubble continues, its risks to investors, financial markets and the economy in general has in no way diminished.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1194.20 as this post is written

As I have previously written, I believe that there is a bond bubble encompassing the entire bond market.  While for many reasons one might not expect the bond market to become a bubble, nonetheless such a bubble has occurred and it is now simply enormous.  This bond market bubble stands out from other bubbles in history in both size and duration.

As one can see in the chart below, from Doug Short’s site on 10-4-10, the 10-Year Treasury Yield (blue line) has been on decline since the early ’80s:

click on chart to enlarge image

This decline in bond yields has been exceedingly munificent to the economy in many different ways.  As well, the bond bubble has been very beneficial to a range of asset classes.   On the above chart, one can see the performance of the S&P500 in green during this period of falling interest rates.

Of course, if one believes the bond market is a bubble, then a pivotal question becomes when will the bubble “pop?”  This question is difficult to answer, as there is a complex interaction between various factors fueling this bubble.

One important factor is that of additional Quantitative Easing (QE).  Many believe that such efforts will further depress interest rates.  Various estimates seem to generally support the idea that $2 Trillion of additional QE would depress 10-Year Treasury rates (currently at 2.48%) by approximately 100 basis points.  While I believe that such an effect may be possible, it is likely such an impact is overstated.

For many reasons, it is tempting to conclude that the bond bubble will last for years.  In fact, I am not aware of anyone who is predicting its imminent demise, i.e. “popping.”  However, I believe, from an “all things considered” basis, that the “popping” of the bond market will happen in the short-term (i.e. likely within 6 months, and possibly even yet in 2010).  I make this judgment based upon many different factors.  Such a bursting of the bond bubble will have immense ramifications on many levels; I have already discussed the threat of rising interest rates in an April 6 post.

Another critical issue with regard to the bond bubble is the following:  If one believes that there is a bond bubble that is serving to unduly depress interest rates, what might be the “natural” interest rate – i.e. one that may endure after the bond bubble pops?  I may discuss this, as well as further define the timing of the bond market “top”, in future posts…

A Special Note concerning our economic situation is found here

SPX at 1137.03 as this post is written

A sentence from the abstract is particularly interesting: “We conclude by arguing that economic theory provides little guidance as to what
should be the “correct” level of asset prices —including housing prices.”

My comments:

This is the latest effort from The Federal Reserve which questions whether asset bubbles,  in this case the Housing Bubble, can be accurately identified as they form.

While one may argue as to whether economic theory can accurately spot asset bubbles, there definitely is a chronic need to do so – as well as to take proper remedial action.  As I wrote in an April 8 post, “Our societal inability to spot and prevent asset bubbles is problematical.”  We simply can’t afford to go through numerous asset bubble booms and busts.   This issue is especially critical now given that there are numerous large asset bubbles currently in existence on a global basis.

A Special Note concerning our economic situation is found here

SPX at 1079.47 as this post is written

From the story: “The health-care products firm sold 10-year bonds with an interest rate of 2.95%, or a risk premium of 0.43 percentage point over comparable Treasurys.”

The story provides an overview of the strong market environment for both corporate and junk bonds.

My view is that the entire corporate bond market is in a bubble.  This bubble is related to the bubble in U.S. Treasuries which I have previously commented upon.

A Special Note concerning our economic situation is found here

SPX at 1092.54 as this post is written

While most people wouldn’t think of the bond market as having bubble characteristics, nonetheless such a bubble has developed.

The article mentions several vulnerabilities the bond bubble faces.  I would add that a major vulnerability is a repricing of risk due to perceived asset quality, due to a variety of issues.

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SPX at 1086.84 as this post is written

chart courtesy of StockCharts.com

(one can click on the chart to enlarge the image)

Maurice Walker’s accompanying comment:

“The Keynesian Cure Never Works

The US had a massive malinestment (An investment in wrong lines which leads to capital losses. Malinvestment results from the inability of investors to foresee correctly, at the time of investment) in housing induced by affordable housing mandates, easy money from the Fed, and Fannie and Freddie guaranteeing mortgages that they had no business guaranteeing.

You cannot get over a debt infused recession with more debt. You have to work off the malinvestment. This is why the Keynesian cure never works. Just look at Greece.

But instead of working off the malivestment, we are trying reinflate the housing bubble with more spending. We are trying to reinflate the economic bubble with the stimulus package.

The Fed has to keep pressing the accelerator faster and faster to main tain the same simulative effect. But if the keep doing this it will cause inflation to arise. Additionally, the Fed already engineered a runaway expansion of the monetary base, that will generate explosive inflation. The borrowing needs of Obama’s record-shattering deficits will only exacerbate the effect. We are moving from a housing bubble to a government debt bubble that is going to ultimately collapse the dollar.”

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SPX at 1092.58 as this post is written

Of course, investing in bubbles can be profitable.  As I wrote in the December 3, 2009 post, “Investing in bubbles can be extremely profitable on the way up; however, for the “long” investor they can produce huge losses if one doesn’t time the exit appropriately.”  History has shown that the (vast) majority of investors don’t time the exit appropriately.

While I have extensively written of how problematical the asset bubble situation is today, it should be noted that others have written to the contrary.   The April 25 2010 post concerning work by Frederic Mishkin and an April 27 article by James Picerno are two prominent examples.

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SPX at 1085.04 as this post is written

In that speech, he refers to Frederic Mishkin’s speech of May 15, 2008.  It should also be noted that Mishkin offered similar thoughts in a Financial Times op-ed of November 9, 2009.

There is much I can comment about in each of Mishkin’s commentaries about bubbles.  For now, I will limit myself to the following:

Here is a passage from the aforementioned 2008 speech which I found most interesting:

“…monetary policy should not try to prick possible asset price bubbles, even when they are of the variety that can contribute to financial instability. Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good. Instead, monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability. This monetary policy response should prove sufficient to prevent adverse macroeconomic effects of some types of asset price bubbles.”

I interpret this (and other points in his speech) as (in effect) saying that monetary policy shouldn’t be used to prevent bubbles, but it should be used to “clean up the mess” should they “pop.”

This “mindset” seems to be prevalent now among policy makers.

I believe this overall “treatment” of bubbles is frightfully perilous, has already created immense damage, and will end very badly.

It appears as if not only are we (as a nation) downplaying the risks of bubbles, but also are continually unable to identify their existence.

As I wrote on March 29: “I strongly disagree with those who think that bursting bubbles are not something to be unduly concerned about….While it may be pleasant to ignore the existence of bubbles, and downplay the potential significance of their bursting, I believe that the existence and prevalence of bubbles in today’s worldwide economy is perhaps the largest threat to achieving Sustainable Prosperity.”

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SPX at 1217.28 as this post is written

http://www.cnbc.com/id/35078010

I would argue against those who believe that bubbles could start to form or that they are just beginning to form.  I strongly believe that there are many bubbles in existence right now, and the implications of such are massive.

Over the last few months I have written quite a few posts on bubbles, and those posts can be found on in the “Bubbles” category listed on the right-hand side of the home page.

SPX at 1090.18 as this post is written

The question raised was “What would have to occur before you considered moving bullish?”

I will answer this question in the context of the general stock market (S&P500).  As readers of this blog know, I have repeatedly expressed doubts as to the sustainability of this stock market rally.  I continue to view it as a bear market rally, albeit a strong one.  If this indeed proves to be a bear market rally, by definition it will go below the 666 March low.  There are a variety of technical, fundamental, general economic, and “behavioral” characteristics of this stock market rally that cause me to draw such conclusions. 

Additionally, as I have previously stated there are a lot of factors and conditions in various other markets (outside the stock market) that cause me to be very concerned.  Posts explaining these concerns can be found under the “Investor” category on the right-hand side of the home page.

Another concern that I have is that, as stated in yesterday’s post, I view many asset classes as being in bubbles now.  This is a very serious condition.   Investing in bubbles can be extremely profitable on the way up; however, for the “long” investor they can produce huge losses if one doesn’t time the exit appropriately.  While I view some bubbles as being bigger than others, if the markets enter a “general liquidation” phase like they did in 2008 and most asset classes prove to be tightly correlated, as they were in 2008′s decline, there would be widespread severe losses throughout most asset classes.

A few years ago I ran across a quote that I found most valuable.  In essence, it said that the last place you want to invest is in an asset class whose bubble has popped.

To conclude, before I would change my overall stock market stance to “bullish,” I would want to see an overall market environment considerably different than that currently existent.   While I can’t exactly specify the parameters of this change, because so many factors are involved, I think a change to “bullishness” will be plain to see, if not explicitly stated, in the blog posts. 

One other thought…bear markets can last for years and can make many turns.  Assuming we are in a bear market, the ultimate low could be years away.

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SPX at 1111.62 as this post is written