Bond Bubble?

From RGE: Will U.S. Treasuries Be the Next Bubble to Burst?

In 2008, the Treasury market had its best annual rally in more than 25 years on fears of global credit crisis, recession, deflation. 10yr and 30yr Treasury yields fell to all-time lows and T-bill yields even dipped into negative territory for the first time since the Great Depression. The total return of the 30-year bond was c. 45%, its best year since 1982. Treasuries in general returned 14%, outperforming S&P 500 by 53 percentage points

In 2009, any signs of a less than dire economic outcome as deflation may burst the bubble in Treasuries. With the U.S. government expected to issue between $1.5 trillion to $2 trillion of debt into the $5 trillion Treasury market to finance its rescues of the financial system, the risk of a sudden drop in prices is growing. 10yr and 30yr Treasuries are still yielding between 2-3%, 2yr notes less than 1%, T-bills near zero. The TIPS market is anticipating less than 0.5% annual inflation for the next 10 years (ML)

Bubble Origins

This bubble is motivated by fear rather than greed. Investors are seeking to protect themselves against deflation and declining stock markets by blindly acquiring "risk-free" government bonds (FT)

Institutional investors also contributed to the bond bubble. Pension funds, insurers and others have sold off toxic securitized triple-A rated bonds and replaced them with Treasuries. Government bonds are attractive for diversification purposes since they have held up while just about everything else in their investment portfolios has collapsed (FT)

The Federal Reserve's signals that it might buy longer U.S. government maturities added momentum to the epic rally (FT)

How Bad Will the Crash Be?

The median forecast of 19 primary dealers is that 10yr bond yields will rise to 3% and 2yr yields will rise to 1.2% in 2009 (Bloomberg)

Because of the low income on Treasury securities, it would take only a small rise in yields for total returns on Treasuries to turn negative (Merrill)

Given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time (Hussman)

The last time investors lost money on U.S. government bonds was the year after the 1998 bailout of LTCM and Russia's default sent investors rushing to Treasuries. Yields on 10-year notes rose to 6.44% in 1999 from 4.65%

Timing the Crash

If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it (Hussman)

The specter of deflation and Japan's experience in the 1990s suggest bond yields could fall significantly further – 10yr JGB yields went on to find a low of 0.45%despite massive fiscal stimulus. Ironically, it was the start of quantitative easing in March 2001 when yields ticked up (JPMorgan)