A Bubble in the Bond Market?

Jeremy Siegel and Jeremy Schwartz claim there is a U.S. bond bubble:

Ten years ago we experienced the biggest bubble in U.S. stock market history…. A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites…. We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic….

While they may be right that bond prices have gone up because of economic pessimism and the associated low interest rates, there is good reason for the pessimism. It’s called a recession, not just any recession but a balance sheet recession. The balance sheets of households in particular have deteriorated so much they are back to where they were about 20 years ago. It will probably take years to heal household balance sheets. If so, there is little reason to believe there is going to be a robust economic recovery anytime soon that will push up interest rates and cause bond prices to crash. The importance of weak household balance sheets cannot be overstated. It is the main reason why the federal government balance sheet is currently growing (i.e. the contraction of household balance sheets is being offset by the expansion of the government balance sheet) and therefore is, in part, indirectly responsible for all the concerns about exploding fiscal deficits. Siegel and Schwartz try to dismiss this concern by saying the problem is overstated but I don’t buy it. Neither do the economists in the Survey of Professional Forecasters. They see a weak recovery at best at least through 2011. Even if one accepts Siegel and Schwartz’s view that there is excessive pessimism in the market it is still hard to talk about bubbles in the bond market like on does with the stock market as noted by Brad DeLong.

In short, there is economic weakness a far as the eye can see and this suggests interest rates will probably be low for an extended period of time. Therefore, even if we do have a bond bubble it is not going away anytime soon. As Colin Barr says, for now we may be stuck with an unpoppable bond bubble.

Update: Felix Salmon and Karl Smith make similar points.

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