What is the bond bubble

What if the bond bubble bursts?

The greatest excesses are currently taking place in the bond market. The Market explains what will burst the bubble and where the money from bond sales could go.

For years, the expansionary monetary policy has been driving asset prices higher. Because of this, many exchanges are expensive today. The biggest excesses are currently not occurring on the stock market, but on bonds.

This is especially true for bonds with a very long term. The yield on 30-year US Treasuries has fallen to an all-time low. Because rates and interest rates move in opposite directions, their price is accordingly higher than ever before. And this despite the fact that the US has a huge deficit in the national budget.

The development of the Republic of Austria's centenary bond is even more impressive. The course has advanced 75% since the beginning of the year. It has doubled since the 2017 issue, outperforming Amazon and Netflix, the two best-performing FAANG stocks:

Government bond beats FAANG shares

100-year loan from Austria
Amazon (in €, adjusted)
Netflix (in €, adjusted)

"Bonds are damn expensive," writes hedge fund legend Cliff Asness in a report. This can be seen, for example, when comparing nominal economic growth with the interest rate on ten-year government bonds. In equilibrium, the values ​​should roughly correspond. In the US, however, interest rates have been below the growth rate for years:

Kevin Duffy from the US investment house Bearing Asset Management speaks bluntly of the biggest price bubble of all time. In his opinion, its core are the distortions in government bonds, whereby the excesses have long since gripped other segments such as high-yield and corporate bonds, car loans, large-cap technology stocks or passive investment instruments.

A bubble of superlatives

That also makes the bond bubble dangerous: "The last two speculative bubbles were limited to technology and real estate in specific sectors," says Duffy in an interview with The Market. "The bond bubble, however, is a monster of an entirely different nature."

He explains the run on bonds with the expectation of investors that the central banks will launch new stimulus programs due to the economic downturn and buy government bonds regardless of the price. The buoyancy is reinforced by speculators who like to throw themselves into well-performing investments - and these are currently bonds.

Towards the end of an exaggeration, according to Duffy, an effect like that of a black hole can often be observed: More and more money flows into the center of the bubble, while the first problems arise on the periphery.

This was evident both when the dot-com bubble burst at the turn of the millennium and in the raw materials bubble in 2008. Although Internet stocks crashed in March 2000, the Nasdaq Composite picked up again in the summer because investors in stocks of large IT equipment companies such as Cisco Systems, Lucent Technologies or Sun Microsystems fled.

The fact that their business in turn was heavily dependent on the demand of the collapsing Internet companies was completely neglected in the mania. And in 2007, investors believed emerging economies were immune to the weak growth in the West. All the more money then flowed into the stock exchanges there and into raw material investments, even though the financial crisis had already begun to smolder.

First warning signs

Today, the ongoing correction in the stock and bond prices of companies like Tesla and Netflix could be an early warning sign of the bond bubble bursting, Duffy thinks.

A credit event could also explain the situation. For example, General Electric's stocks and bonds have experienced severe fluctuations in the past few days after allegations of immense Enron-style balance sheet fraud were raised. A collapse of the former industrial icon would shake the credit markets, as it drags almost $ 110 billion in debt with it:

General Electric bonds collapse

Price of the perpetual bond from GE (Coupon 5%)

Duffy also sees signs of deterioration in credit conditions in the financing of exploration and production companies in the energy sector, despite the low interest rates. "These companies are currently struggling to get money." Interest rates on small business loans, car financing and mortgages on commercial real estate have also increased.

The ultimate end for the bond bubble would be the rise in inflation, because the central banks would then have to counteract this and raise interest rates. Since inflation remains low worldwide despite the spasmodic attempts by the central banks to stimulate, hardly anyone believes in this scenario at the moment.

But the large supply of money, which the central banks will hardly ever be able to siphon off, and the increasing protectionism could one day cause a nasty surprise.

Strategies for the bond quake

But where will the money from the bond market flow to when the bubble bursts one day?

Earlier excesses show that "anti-bubbles" also form after every exaggeration. These then usually arise in segments that have been completely neglected by the investors in the mania. When a bubble bursts, these areas therefore hold the greatest potential.

In 2000, for example, these were the disrespectful old economy stocks from traditional economic sectors such as industry, mining and transportation. They marked their lowest point almost exactly at the height of the technology bubble.

If the bond bubble bursts, the raw materials sector could prove to be a safe haven - especially if inflation, believed to be dead, actually picks up. Because the associated rise in interest rates is likely to be accompanied by a global recession, investments in the energy and industrial metals sectors offer little security.

The prospects for gold and mining stocks look more promising, the value of which is reversing to confidence in the central banks. There is also potential to open up in agricultural commodities, which are less dependent on the economic cycle.

According to Duffy, the retail sector could also offer opportunities, where the belief that Amazon will rule the world has pushed prices down to a depression level.