Sunday Musings: Bond Bubble Thoughts

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Over the past year, much has been written in the mainstream media about the potential for a bond bubble bust. Those who have bet on that scenario by shorting treasuries have suffered big losses as the bond rally, supported by lower interest rates, has actually gathered steam.

The wild card was the fact that, as I posted yesterday, we only had a stimulus induced recovery and not one based on true demand for goods and services. As a consequence, interest rates continued their downward spiral as bond prices rallied and the economy slowed.

The question now is what could bring this bond rally to an end?

The obvious reason would be a real pickup in economic activity, which would cause interest rates to rise over time. While possible, I simply can’t see it happen given the current back drop.

Through my lens, we are far more likely to see further weakening in GDP during the second half of this year as opposed to a recovery. The Fed even has said this much and, while the bond market has caught on, the equity market still has not gotten the message. Once it does, increased downside risk will come into play, and a move back into bear market territory is a distinct possibility. That would translate into low interest rates staying with us for the foreseeable future.

Another factor that eventually could bring this bond rally to an end is the continued tremendous borrowing appetite of the U.S. government to finance its ever rising deficits. With no serious deficit reduction efforts in place at this time, those who buy our bonds may eventually demand higher rates of returns due to increased risk causing bond prices to falter. While this may be years away, it should be a concern nonetheless.

Some have argued that inflation will eventually cause interest rates to go up, but that scenario is very unlikely as the odds are increasing that we will moving into a Japan like deflationary environment.

Then there is always the unknown event that can wreak havoc with any of the above. From a practical investment point of view, and to guard against the unforeseen, I treat our bond holdings just as I do equities. I follow their trends and use a trailing sell stop (5% for bond funds) to be executed should the need arise.

We are living in a very uncertain economic environment with no clear direction recognizable on the horizon. No one can predict the future, so it pays to be cautious by using a sell stop discipline, just in case things turn out opposite of what you had anticipated.

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