Investors' raging demand for safe assets over the past six months may have created a bubble in the Treasury market — and some onlookers...
NEW YORK — Investors’ raging demand for safe assets over the past six months may have created a bubble in the Treasury market — and some onlookers expect to hear a bursting sound any minute now.
A bubble exists when asset prices climb well above their intrinsic value, as occurred with stocks in 1999 and housing prices in parts of the country in 2006. Often the bubble’s end is marked by disruptively sharp price declines as investors abruptly conclude assets are overvalued.
There are mixed views about whether the recent buying spree in the Treasury market has pushed up prices to unjustified bubble levels.
The rally, which has also sent bond yields plunging to multiyear lows, was fed first by fallout from the subprime-mortgage crisis, then by growing worries about a recession.
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“I’m one who believes there is a bubble. Everyone has been focused on Treasurys because they are afraid of the alternatives,” said Michael Metz, chief investment officer at Oppenheimer. “It has nothing to do with the value of Treasurys, which are overvalued. The stampede has been because of fear.”
Metz believes selling will start soon, particularly for the longer-term 10-year note and the 30-year bond.
Furious buying in January sent the 30-year bond’s yield below its 1977 debut level of 4.15 percent, to a historic low of 4.13 percent. The 10-year yield, meanwhile, touched a four-year low of 3.29 percent.
In Metz’s view, foreign demand for long-term Treasurys is waning, as overseas investors back away from dollar-denominated assets and opt for instruments in the higher-yielding euro, British pound and Swiss franc.
Metz expects that trend to accelerate, driving long-term rates well above their current paltry levels.
People who think a bubble exists also claim the Federal Reserve’s monetary policy is not responding appropriately to rising inflation — but will be forced to soon.
The Treasury rally was in part a reaction to the Fed’s interest-rate cuts and the bank’s professed willingness to cut rates further to support a flagging economy. Traders often buy Treasurys, particularly the two-year note, and push their yields lower when Fed rates are expected to decline.
Bubble theorists worry that the rally and the Fed moves are at odds with news about inflation. The Commerce Department last month said inflation was 2.7 percent in the fourth quarter, well above the Fed’s comfort level of 1 to 2 percent.
If future reports suggest inflation jumping out of control, the Fed may have to forgo its economic-stimulation program and take steps to lower prices, the argument goes. That would send bonds falling.
Many analysts do not buy the idea the Fed will halt rate cuts soon. Paul Nolte, director of investments at Hinsdale Associates, thinks the Fed made clear with its rate cut last week that it is preoccupied with economic weakness and likely to keep cutting rates.
If that is true, investors won’t want to liquidate Treasurys.
Others question just how big a threat inflation poses. The creaky economy is likely to slow the march of inflation as the year unfolds, said Sal Guatieri, an economist at BMO Capital Markets.
And there are many who think the “fear trade” may not be going away any time soon. Lyle Gramley, a former Fed governor and senior analyst with the Stanford Financial Group, thinks buyers of Treasurys will continue to appear, no matter how elevated the prices and how weak the yield.
People will continue to demand the safest assets they can find as long as worries persist about a recession and the subprime-mortgage and bond-insurance crises, he said.
Whether an observer believes there is a bubble or not hinges partly on whether that person thinks Treasurys are overpriced, although the fact that prices are very high does not necessarily mean they aren’t justified.
“I wouldn’t call it a bubble, because the motivation for buying them is different than with the housing bubble,” said Steve Rodosky, head of Treasurys trading at PIMCO, the world’s largest bond fund. “This is more of a flight to quality.”
This means that, if other assets really are as weak as perceived, Treasurys could be worth the heady prices investors have been willing to pay.