The Yellen Bond Bubble

• Bond yields are dangerously low.
• Prices are falling and inflation expectations have become unanchored.
• The Fed will have to act, and bond prices will have to fall.
• Stocks are more remunerative than bonds right now.

Bond prices have soared and bond yields have declined by one-third since Janet Yellen became Fed chairman. Over the past six months, five-year expected inflation has declined from 2% (the Fed’s target) to 1.2%, a decline of 40%, and far below the Fed’s target. The Fed’s inflation target has lost credibility in the bond market.

In 1933, Irving Fisher wrote about deflation risk: “The more the economic boat tips, the more it tends to tip.” On the same topic, Ben Bernanke said that “the best way to get out of trouble is not to get into it in the first place”. In other words, deflation is much easier to prevent than to correct, as the ECB is learning at this very moment.

One of the Fed’s stated goals is to anchor expected inflation so as to avoid inflationary or deflationary pressures from building. Something happened in 2014 which caused inflation expectations to become unanchored, perhaps the premature taper of QE or the constant talk of a rate hike. It doesn’t really matter what caused expectations to become unanchored, because inflation expectations are the Fed’s job to manage, not an exogenous variable to be lamented. Deflation is a currency-specific monetary problem, and there is no such thing as “global deflationary pressure”. The Fed’s failure to anchor inflation expectations has created a big bond bubble that will need to be popped.

It is difficult to argue that the bubble won’t ever be popped because there is a “new normal” of low everything. The only way that we can have such a new normal is if the Fed were to permanently abandon its inflation target. Assuming it doesn’t do that, assuming that at some point it moves to raise inflation and expectations, the bubble will burst. We can’t live forever with five-year Treasuries yielding 50 bips less than the Fed’s inflation target.

I have just argued that the Fed will have to act in order to raise both expected inflation and bond yields. But please note that the bond market strongly disagrees with me: it has made it clear that it does not expect the Fed to do anything. If it agreed with me, we wouldn’t be seeing these frightening numbers.

Nonetheless, it is quite likely that, at some point this year, the FOMC will wake up and notice that things are slipping out of control, and will be forced to  take decisive action to raise expected inflation. For example, it could eliminate interest on excess reserves and launch an open-ended QE. If such a policy proved successful, bond prices would fall substantially (and deflation risk would be banished).

The do-nothing option is not really viable, because we are already seeing signs of deflation. Commodity and producer prices are falling, as is headline inflation (both CPI and PCE). How much of this is the transitory effect of falling oil prices and how much is a deeper phenomenon is not yet clear. But the fact that hourly wage rates are falling suggests that this problem may go deeper than the oil situation. The price of oil has declined many times before without causing general deflation (aside from the Crash which was about a lot more than oil prices).

Investment Conclusion

When bond yields are below the Fed’s inflation target, I think bond prices have entered risky terrain. The current low yields make stocks a better investment alternative (with expected total return around 7-8%), but stock prices are also vulnerable to higher bond yields, because higher yields compress the equity premium. Nonetheless, I feel safer being overweight equities and underweight longer-dated bonds. Stocks are an investment which will over time reward you with cashflow irrespective of subsequent price movements. Don’t buy for appreciation, buy for total return. Note that the market’s current dividend yield is higher than the 5-year bond yield, and about the same as the 10-year.