Email of the day (1)
Comment of the Day

December 07 2012

Commentary by David Fuller

Email of the day (1)

On a bond bubble:
"Hello David, just a brief comment on the bond markets. I have been managing fixed Income for 25 years. I would make a few brief comments just to keep group-think in check.

"If this is a bond bubble it is the most widely anticipated 'bubble' I have ever seen; everyone is identifying it. A second point is that the debt de-leveraging process and time frame is not like emerging from a less leveraged recession. It is a pernicious and deflationary phenomenon. Witness that for all the stimulus the CBs are throwing at the issue, it has been terribly hard to create growth, inflation or cause rates to rise. We are getting minimal aggregate GDP growth in the developed world even with historically unprecedented base money creation. In addition, governments will be doing all they can to contain if not reduce costs and can be expected to shrink over the next 20 years as a percent of GDP. So no stimulus is coming from leveraging as we have had for the past 30 years and no stimulus is coming from government growth. Periods such as this can take 10-20 years to relieve debt levels through default, repayment, inflation and growth, even without deteriorating demographics. In the meantime, the leveraged part of economies (govt, banks, housing (?) hobbles along). And there is limited upward pressure on wages and input prices upon which inflation gauges are based. So I would just posit an alternate scenario. HY corporate bonds should offer a powerful coupon and repayment prospects that might just be one of the best margins of safety in a continuing hobble-along environment (even though 2013 will be stronger). And the consensus waiting for the bubble could be like waiting for Godot. Just an alternate scenario to be considered. One other brief point: shorting debt is painful - you buy a bond and you receive a coupon, you short sell a bond and you pay the coupon away. So you have to get your timing right or shorts are an expensive position to carry. So keep duration short, buy the dips and enjoy the carry. And if you choose to short, buy equity puts rather than shorting rates, it's cheaper.

David Fuller's view Many thanks for your informed and detailed email which I greatly appreciate. I will repeat what may be the most important of your many interesting points:

"Periods such as this can take 10-20 years to relieve debt levels through default, repayment, inflation and growth, even without deteriorating demographics."

My premise is that if there is any bubble in today's global markets, it is most likely to be bonds, given their 30-year plus bull market which is still being extended by QE. There are many other disquieting signs, including the surging issuance of fixed interest investments, investors' ravenous appetite for them, and the often negligible yields that we now see. Surely these are bubble characteristics.

All big, long-term bull markets are rational and justified for much of their duration, but they eventually become manias and therefore bubbles, which are a lot easier to see with hindsight. However, they all include some of the points mentioned in the paragraph immediately above.

The challenge of bubbles is that they are often the most rewarding opportunity, up until the time they eventually burst. We have all seen this before. Seductively, bubbles therefore appear reassuringly safe and rational, while they are still inflating. Investors inflating the bubble become overconfident.

The US and other similar bond market bull trends clearly have yet to burst. If the markets you are dealing in are destined to follow Japan's script, then the participants will continue to profit for an indefinite period. However, if / when the US and some other countries with similarly record low yields emerge from their economic sloughs in the next few years, as I suspect, their bond bubbles will burst.

Remember, the warnings of bubbles always come 'too soon'. For the many who are participating in these low yielding fixed interest markets, good luck and more importantly, use trailing stops and / or exit quickly when the trend falters, and do not be tempted back in by the first sharp setback. Probably the most important signal, other than clearly adverse price action, would be the end of QE and rising short-term interest rates.

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