In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.
Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.
So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:
1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war; reduced military spending; the peace dividend
3. The lowering of global trade barriers and tariffs
4. China’s entry into world commerce and its export of wage and retail disinflation
5. The bear leg of the commodity supercycle
6. Improvements in business technology, especially in inventory management1
But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years2:
1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports.
2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory
3. Risk aversion in the aftermath of the crash
4. The dollar carry trade
Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.
But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.
# 1Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"
# 2Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.