Signs indicate Treasuries could be a bubble about to burst

ByABC News
June 12, 2012, 8:48 PM

— -- Last month, the government put $25.5 billion of 10-year Treasury notes up for sale. The notes carried a 1.75% interest rate, well below the inflation rate. Anyone who bought a note would lose money to inflation for a decade.

Who would take that deal? Plenty of people, apparently. The Treasury received $2.90 in bids for every $1 in T-notes it offered.

Treasury yields have been falling since 1981, when the 10-year T-note yielded more than 15%. At current record-low levels — 1.66% — Treasury yields have much more room to rise than fall. Yet investors can't get enough of them.

Is this yet another bubble, like tech stocks in the 1990s and junk mortgages in the past decade? Surprisingly, most experts say probably not. Instead, the public's taste for Treasuries has been whetted by the bursting of other bubbles — specifically, the housing bubble and the European debt bubble. "Everything else was a bubble," says Peter Kendall, co-editor of the Elliott Wave Financial Forecast. "The Treasury market was the safety valve."

A bubble has a very specific meaning in finance: It's not just the normal top of a bull market. A bubble is a period of widespread, overwhelming belief that an investment will continue to soar higher, no matter how high prices have already moved. In other words, an ordinary bull market is not a bubble. It probably is a bubble when everyone from your taxi driver to your pension fund manager loves an investment.

Supposedly, Joseph Kennedy, father of President Kennedy, realized the 1929 stock market was a bubble when his shoeshine boy started offering him stock tips. Kennedy figured that if everyone was in the market, there weren't many people left to push up prices.

Quite a love affair

You can certainly make the argument that investors love bonds dearly. Investors have put an estimated $864 billion into bond mutual funds from the start of the bull market in stocks in March 2009 to the end of May. They have yanked nearly $200 billion from traditional open-ended stock funds during the same period.

And it's not just mutual fund investors who are in love with bonds in general and Treasuries in particular. China owns $1.2 trillion of Treasuries. Japan owns $1.1 trillion.

The most recent 10-year T-note auction wasn't the most frenetic. That honor goes to the Dec. 13 sale, when the Treasury got $65 billion in bids for $25.8 billion in T-notes. At the last auction of 28-day Treasury bills — investment rate 0.041% — the Treasury got a staggering $148 billion in bids for $33.8 billion in available T-bills.

Axel Merk, manager of the Merk Hard Currency fund, thinks that the Treasury market has been disturbingly quiet. "When you buy long-term bonds, you have volatility — it's a wild ride out there," he says. "In recent years, it's been very smooth sailing, and when volatility goes below the historic norm, that's the definition of a bubble."

The danger with any bubble is when it bursts. People who trade bonds for a living are usually concerned with the price, rather than the yield. Bond prices rise when interest rates fall, and vice versa. If rates were to rise 1.5 percentage points, a current 10-year T-note would fall 23% in price. A 30-year Treasury bond would fall 47% with a similar rise in yields.