Use Google to search for the term "bond bubble" and you get more than 2 million hits. This isn't terribly surprising, as the past decade has been written by one bubble-and-burst after another. Hit people with enough shoes, and they'll search in angst for the next one to drop.
Some disagree with this bond bubble talk. But let's assume for the sake of argument that a bubble exists. An important point, then, needs to be addressed. I've always thought there were two types of bubbles: One is a valuation bubble, the other is an income bubble. Distinguishing between the two is extremely important.
Here's the difference.
A valuation bubble is what dot-com stocks went through in the late '90s. With some exceptions, the revenue generated by most dot-coms (even the ones that failed) was genuine and rational. It wasn't crazy that Amazon (Nasdaq: AMZN) was selling books over the Internet, or that Yahoo! (Nasdaq: YHOO) was selling banner adds. It was the valuations investors placed on that commerce that was certifiably insane -- and eventually bled investors dry in the aftermath. When investors put crazy valuations on an otherwise good idea, you get a valuation bubble.
An income bubble is an entirely different beast. In an income bubble, valuations look normal. It's the commerce that's lost its mind. A good example is banks and homebuilders in the middle of last decade. I recall looking at Beazer Homes (NYSE: BZH) circa 2005 and thinking, "Hey, this company trades at like 10 times earnings and less than book value! That's cheap!" (Idiot). In hindsight, its income was the bubble.
Ditto for banks like Citigroup (NYSE: C). For most of the middle of last decade, large commercial banks traded at 10-12 times earnings and had dividend yields of 4%-5%. That seemed like a good deal. And from a valuation sense, it was. But the way they made money -- hawking subprime junk to widows and orphans -- was the bubble. And it was huge. When companies are temporarily able to pull in money through really idiotic means, you get an income bubble.
Income bubbles are much more dangerous than valuations bubbles, if only because they're veiled. Valuations bubbles are relatively easy to spot. But spotting income bubbles requires detailed knowledge of an industry's dynamics -- something even insiders manage to fumble. Many people saw the dot-com crash coming, but very few people saw the financial crisis coming, regardless of what they say.
How is this relevant to today's bond bubble? Because I think you can make a case that Treasuries are both a valuation bubble and an income bubble. It's a valuation bubble in the sense that anyone willing to lend money at 3.65% for 30 years to a government with a dysfunctional legislature and a trigger-happy Fed has a painful ignorance of history. And it's an income bubble in the sense that, with the dollar as the world's reserve currency, many foreign investors are essentially forced to buy these bonds whether they think they're a good deal or not.
Some might say the dollar's status as a reserve currency is what justifies low rates; it makes Treasuries extraordinarily safe. That's probably true for the time being. But it seems absurd to rely on this idea that the-world-must-forever-and-always-worship-dollars continuing indefinitely, as so many Treasury investors are. A quote on this issue that sticks in my head comes from a director-general of the China Banking Regulatory Commission, who said in 2009: "Except for US Treasuries, what can you hold? … For everyone, including China, it is the only option." That's what big trade imbalances will do to you. He continued: "We hate you guys. Once you start issuing $1 trillion-$2 trillion … we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."
In fairness, that's slight hyperbole. China has moved up in the world thanks to America's appetite for the stuff it makes -- a condition that requires it to buy our Treasuries. I don't think the dollar is going to turn into toilet paper overnight. But I do think the current arrangement where the rest of the world lends by force while we spend with abandon is one that cannot last forever. At least to the degree it's at today. It gives us an unfair living-standards advantage that many other countries would love to have and will aspire to achieve. In my book, that qualifies as a first-rate income bubble.
How will this end? No one knows. I sure don't. I just know that you should invest in things where the odds of success are in your favor. And with Treasury bonds at these prices, they're firmly not.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
