Followers of the market for U.S. government bonds have started tossing around the term “bond bubble” with increasing frequency. The concern is that interest rates on long-term Treasuries have gotten so low that investors face high risk (if interest rates rise, the value of securities will fall) at low return.
My favorite academic bond analyst, J. Huston McCulloch, seems to share this view.
In the May 30 edition of his web page, he writes,
10-year TIPS [inflation-indexed Treasury securities] therefore have a higher expected return, in either real or nominal terms, than nominal notes of similar maturity, for every one of the 34 forecasters polled. At the same time, the indexed notes are essentially risk-free to their respective maturities, while the inflation risk on 10-year nominals is considerable. This is what is known in the economics literature as second order stochastic dominance. This means that no informed rational risk-averse investor with these inflationary expectations should be investing in the nominal notes when the indexed notes are available at current rates.
The way I interpret McCulloch’s analysis is that the long-term expected inflation rate that is implicit in Treasury bonds is implausibly low.
For Discussion. In theory, if McCulloch is correct, it should be profitable to buy TIPS and short nominal Treasuries. What are the risks and costs of doing so?
READER COMMENTS
Jim Glass
Jun 16 2003 at 7:36pm
Maybe so, I’ve been hearing that for some time. But if so, it’s nothing like Japan’s bond bubble. When long bonds pay basically zero figure what happens to their value if rates rise a few points (maybe with the “inflation cure”).
Rudy Dornbusch:
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The second mega-risk scenario involves a Japanese financial meltdown… The ingredients are two: an economy that stubbornly refuses to turn up—and nobody having a clue of how to change that, and a financial superstructure that is out-and-out bankrupt. This is not just the banks and the insurance companies, and retailers and other parts of the private sector.
Importantly, the government is bankrupt. Its debt is larger than that of the US – a country much larger than Japan — or that of all of Europe, again and economy much larger than Japan.
Japan’s finances are mostly stable as long as households wake up every morning and support the status quo by rolling the debt or buying even more in the mistaken belief that this is a plausible investment. Having lost on all their investments, it is not surprising that they hang on to their government’s liabilities as the last straw of hope; ironically, it is the least straw of hope.
One day there will be a creditors strike, the investors leave for foreign assets (just as any delinquent emerging market — the currency crashes, the debt crashes, confidence falls and with it consumption. Japan will be overnight in the Great Depression.
And with Japan goes much of Asia and that means the world will have the single largest shock in 50 years. Far from bottled up in Japan, it will spread everywhere just as was the case in the 1930s…
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“Two Big Risks For the World Economy”
http://econ-www.mit.edu/faculty/dornbusch/editorials.htm
dsquared
Jun 17 2003 at 4:37am
Surely this premium of nominal bonds relative to TIPS justs reflects people wanting to be insured against deflation, rather like the premium on deep out of the money put options?
Arnold Kling
Jun 17 2003 at 12:06pm
D-squared, I think that TIPS dominate nominal bonds even if you are worried about deflation. I believe that TIPS are only indexed to go up with inflation, not go down with deflation.
dsquared
Jun 17 2003 at 1:18pm
Interesting indeed. Though I think that the claim of stochastic dominance is actually bit quickly made. In order to not have to specify a model of the entire forward yield curve (and thus abstracting from potential scenarios in which the reinvestment of the higher coupons on the plain bonds would more than compensate for the differential), he would have to be talking about a 10-year zero coupon bond versus a 10-year TIPS strip. Which is basically comparing a liquid security with an illiquid one, so I’m not so keen on this approach (although the general point that TIPS might be cheap seems appealing; there are certainly such things as bubbles).
"Mindles H. Dreck"
Jun 20 2003 at 8:32pm
This article, and its predecessor are relevant:
http://salsa.bbh.com/news/archives/000361.php?insurance=1
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