No, there probably isn’t a bond bubble

One peculiar legacy of the financial crisis is that, among the financial commentariat, there is a tendency to see a bubble whenever the market for a particular asset rises.
We’ve seen it lately with the resurgence in the stock market, which commentators are quick to say is a built-on-thin-air creation of the Federal Reserve (even though price-to-earnings ratios are the lowest they have been in a generation). And then there are the  modest rises in home prices — also seen as a bubble (even though price-to-rent ratios show no sign of becoming unhinged from reality the way they did in the early 2000s).
But no bubble fears are as widespread as those for the markets for government bonds — in the United States in particular but also in many other nations. It almost passes as a mark of seriousness to argue that Treasuries are the next big bubble to pop, the biggest in a long series that also included the stock market bubble of the late 1990s and the housing and mortgage securities bubble of the 2000s.
That kind of talk heats up whenever bond prices start to fall a bit, as they have in the last few weeks. (The phrase “bond bubble” appeared in major world publications included in the Nexis database 28 times in January, up from two in January 2012). And, yes, bonds have been in a remarkable 30-year rally, their prices climbing as interest rates have fallen almost constantly since the early 1980s.
Of course, bond prices could drop (and, conversely, longer-term interest rates rise). But that change is more likely to occur for good reasons – -because the economy is getting back on track — than for bad reasons, such as out-of-control inflation.
So, I’m not particularly worried that Treasury bonds are a bubble about to pop. Here’s why:
The simplest reason to be skeptical of the bond bubble story? A bubble means that people are buying an asset at ever-rising prices for speculative reasons, not for the fundamental value of the asset but because they are assuming somebody else will buy it at a higher price. I see no evidence of this behavior by buyers of Treasury bonds. They tend to be people looking to get their 2 percent yield and their money back at maturity. And while they may complain that the yield is so low (and the price of the bond, by extension, so high), that they are buying the bond because the guaranteed 2 percent is a better deal than the alternatives — not because they’re convinced that interest rates will fall further and they’ll be able to “flip” the bond at a profit.
But to go a level deeper, it helps to know some basics of finance theory. Think of the interest rate that a Treasury bond pays as a bunch of other rates added on top of each other. If you believe that the market for Treasury bonds is going to collapse, you have to determine why the conventional wisdom, as is priced into markets, is wrong about one or more of these things.
First, there is the future path of short-term interest rates, which is set by the Federal Reserve. Nobody would buy a 10-year bond yielding only 2 percent if they expected short-term interest rates were going to soon rise to 5 percent.  As a starting point, bonds should price in what the market expects the Fed to do in the future. Conveniently, leaders of the Fed have become clearer than ever before about what they expect their future interest rate policies to be.
Fed vice chairman Janet Yellen even gave a speech in November where she uses a slide show to explain her view of what the “optimal path for monetary policy” would look like. The chart shows the Fed starting to raise rates at the start of 2016 and shows short-term interest rates crossing the 2 percent line in late 2017.

This chart, from a slide accompanying a speech by Fed vice-chair Janet Yellen in November, 

shows in blue her view of what an “optimal monetary policy” might look like.

Now, Yellen’s chart could turn out to be wrong. Perhaps economic growth or inflation will take off before 2016, and the Fed will tighten policy earlier. Conversely, there could be a new recession, prompting an even longer wait before rates rise. Another uncertainty is that when Ben Bernanke’s term as Fed chairman ends less than a year from now, his replacement might push the Fed toward a different set of policies.
But investors buying longer-term Treasury bonds know more than they ever did before about what Fed leaders themselves expect interest rate policy to be for the years ahead, and so the prices they pay reflect that. If bond prices fall (and yields rise) because the economy is doing a lot better, that’s a good thing overall, even if it means the value of bonds bought in 2012 fall in value.
Two more components of bond prices are tied to inflation. Investors demand compensation both for the inflation they expect to happen — after all, in 10 years the dollars they get back from the Treasury will be worth less than those they lend it now — as well as some compensation for the risk that inflation could be higher than they expect.
Markets are currently pricing in 2.5 percent annual inflation over the next decade (that’s the difference between what normal bonds are yielding and inflation-indexed bonds). But if it turns out that inflation soars higher, then bonds would indeed be worth less.

This chart shows expected annual inflation over the decade ahead, as implied by market prices. (It is the yield on regular Treasury bonds minus the yield on inflation-protected bonds.)

This is the most plausible case for why bonds could be overvalued. The economists at the Fed and most private forecasting firms believe that as long as there is so much slack in the economy — unemployed workers, idle factories, empty office buildings — inflation isn’t much of a risk. But if they’re wrong, prices could indeed start jumping, and the value of bonds would fall. And note that this also connects to the path of short-term rates; a world in which inflation suddenly spikes to 5 percent is also a world in which the Fed is hiking short-term interest rates more than it expects to do now.
The next factor in bond yields is “liquidity risk,” the idea that Treasuries may be harder to buy and sell in the future than they are today, that investors might have trouble getting out of their positions in the future. It is hard to imagine a world in which the market for U.S.  Treasury bonds is not deep and liquid, however.
And finally, there is default risk. Investors demand some premium on the bonds they buy to cover the chance that they won’t get paid back at all. Companies default all the time, any time there is a bankruptcy. Countries default rarely, but it does happen. Ask Greek bondholders, who, after arduous negotiations, agreed to a restructuring of their debt that amounted to a default, even if it wasn’t called that. But the United States, unlike Greece, has its own central bank, so is less likely to go into default. The nation’s public debt is a lot larger than it was a few years ago, but plenty of nations have done fine for years on end with higher debt burdens.
So unless our political system becomes so dysfunctional that default becomes a real possibility—not for economic reasons, but because, say, Congress reneges on its financial commitments, there’s not much reason to fear default. Even during the height of the debt ceiling debate in August 2011, when a considerable faction of Congressional Republicans was threatening just that, rates fell rather than rose, as investors still viewed Treasuries as the safe place to park money when the world seemed dangerous.
So as long as growth remains slow, inflation low, and the political system exhibits even a modicum of functionality, bond prices are about right. If there is a  “bond bubble,” one of those assumptions has to be wrong. It’s on the bubble heads to decide which to choose.

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/04/no-there-probably-isnt-a-bond-bubble/