T-bond yields raise fears: Inflation may pop bubble in safe assets

The Baltimore Sun reports:

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 market bubble exists when asset prices are driven well above their intrinsic value, as occurred with stocks in 1999 and housing prices in many parts of the country in 2006.

Often the end of a bubble 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 driven prices up to unjustified levels.

The rally, which has also sent bond yields plunging to multiyear lows, was fed first by fallout from the subprime mortgage crisis and then by growing worries about a recession.

"I'm one who believes there is a bubble. Everyone has been focused on Treasuries because they are afraid of the alternatives," said Michael Metz, chief investment officer at Oppenheimer & Co. "It has nothing to do with the value of Treasuries, which are overvalued. The stampede has been because of fear."

Metz believes the bubble is likely to give way to selling 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 Treasuries already 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.

He expects that trend to accelerate, driving long-term rates well above their current paltry levels.

People who think a bubble exists also claim that 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 Fed interest rate cuts and the bank's professed willingness to cut rates further to support a flagging economy. Traders often buy Treasuries, 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.

When are bondholders going to get sick of meager real rates of return? Don't be surprised if we see a dramatic increase in interest rates in a short period of time.This will further decimate the housing market.