Bond Market Bubble?

The FOMC minutes published on Tuesday continued to remind investors of the Federal Reserve’s commitment to ultra-low interest rates. Since then, however, the long-end of the curve has sold-off quite dramatically. The 10-year yield is up nearly 10 basis points and the 30-year is nearly 20 basis points off recent lows. This is partly due to the recent surge in risk appetite as equity markets worldwide continue to ascend to multi-month highs. But more importantly, the temporary correction in bond yields could suggest that the Fed’s so called “QE 2” may be fully priced in.

In a recent survey by Reuters earlier in the month, 14 out of 15 primary dealers anticipated additional quantitative easing at the next FOMC. As such, the market has had ample time to price in the Fed action’s, which by most estimates is seen between $500 billion to $1.5 trillion.

While the Fed would prefer to have higher inflation expectations, there is some evidence that the recent rise in commodity prices and precious metals are beginning to feed through. Just today, the break-even rate for 5 and 10-year Treasuries (the difference between cash yields and inflation-linked bonds) reached their highest levels since June.

According to a JP Morgan survey, this is occurring while bond optimism amongst investors is at yearly high. Extreme levels of sentiment are often viewed as a contrarian indicator and could also suggest why bond prices could be in store for a period of consolidation.

Globalization has synchronized worldwide asset price movement like never seen before and bond markets are no exception. The Eurozone’s 2-year yield is up 20 basis points over the past month and Euribor rates have reached fresh yearly highs as the ECB now seems committed to an exit strategy from easy monetary policy.

If Treasury yields continue to lag behind, then yield differentials will continue to widen out against the U.S. This will inevitably further damage the Greenback and cause asset prices to continue to reflate. At some point, however, the treasury markets will have to respond by pricing in the inflationary affects of the Fed’s actions and cause the bond market bubble to burst.