A Bull Market in Pessimism?
Posted by Brent Everett on Tue, Aug 24, 2010 @ 12:42 PM
Call it a "fear bubble". Individual investors are, for the most part, shunning the equities markets due to the perception of risk. Has this created a bubble in bond prices?
The Economist, in an August 19 article states that "a lot has to go wrong to justify today's rock-bottom bond yields". According to the article, US equity mutual funds have seen an outflow of $7B so far this year, but bond mutual funds have had inflows of $191B. Since bond prices and yields have an inverse relationship, bond investors have recently enjoyed handsome returns.
Has this "rush to bonds" created a bubble in bond prices? Most of the drop in treasury yields can be attributed to a decline in the expected inflation rate. Yet, while investors have piled into nominal bonds, the yield spread over inflation-linked bonds has narrowed, bringing down the implied inflation rate. In fact, some analysts believe that this indicates only a 10-15% probability of deflation over the next five years.
As deflation fears subside, will investors dump bonds and create a violent sell-off? The US core CPI fell to 0.9% in July and there are signs that it may be bottoming. Core producer prices rose faster than expected in July. Bonds may also be expensive when compared to stocks. Analysts at JPMorgan recently calculated the US equity risk premium and concluded that it was at a record high. But, will this be enough to convince investors to start bailing out of bonds? Probably not - at least as long as the central banks keep interest rates low and continue to buy debt.
