Friday, May 10, 2013

Time to Reconsider Bearish Views on Bonds?

In a Fortune article published in 2001, Warren Buffett wrote the following:

Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants.

Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience - a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation

Most financial advisors - myself included - believe that central bank policies around the world have pushed interest rates lower than normal economic forces would dictate.

It is only a matter of time, we believe, before the Fed and the rest of the world's monetary authorities stop their aggressive intervention in government bond markets.  Once this ends, interest rates could move sharply higher from today's historically low levels.

However, writing in today's New York Times, Nobel Prize winning economist Paul Krugman raises an interesting point:  What if interest rates are actually reflecting the true state of global economies? 

Here's an excerpt from today's column (I added the emphasis):

And there’s a lot of bubble talk out there right now. Much of it is about an alleged bond bubble that is supposedly keeping bond prices unrealistically high and interest rates — which move in the opposite direction from bond prices — unrealistically low...

... the interest rate on long-term bonds depends mainly on the expected path of short-term interest rates, which are controlled by the Federal Reserve. You don’t want to buy a 10-year bond at less than 2 percent, the current going rate, if you believe that the Fed will be raising short-term rates to 4 percent or 5 percent in the not-too-distant future. But why, exactly, should you believe any such thing? The Fed normally cuts rates when unemployment is high and inflation is low — which is the situation today. True, it can’t cut rates any further because they’re already near zero and can’t go lower. (Otherwise investors would just sit on cash.) But it’s hard to see why the Fed should raise rates until unemployment falls a lot and/or inflation surges, and there’s no hint in the data that anything like that is going to happen for years to come

Krugman goes on to point out that investors for years had expected Japanese interest rates to move higher, only to watch them grind lower for years on end.

So while I am not totally convinced, perhaps I and the rest of the investment community need to reconsider our simplistic bearish view of bonds.