Wednesday's Market Minute: The Bond Bubble Test, Revisited

There was a fun hypothetical to consider pre-COVID about whether the Treasury market was in a “bubble.” I put that in quotes because a lot of people challenge the notion of whether it’s even possible for U.S. government bonds to be speculative enough to create a traditional bubble. So, let’s loosely define a bond “bubble” as a scenario in which investors are buying bonds because they know the Fed is going to buy them next at a higher price, not because they’re using them as a traditional safety asset in a portfolio.

How would we know?

The thought experiment centers around a hypothetical scenario in which the Fed was expected by the market to cut interest rates, but did not. Of course, that never happened. Every time Fed funds futures were expecting a move, Jay Powell lived up to expectations. But what if he hadn’t? Would yields go up or down? If the bond market is truly an assessment of economic risk, then bond yields should go down after such a disappointment, because it would mean the central bank has endangered the economy by not supporting the system. But if yields climbed after such a disappointment, it would mean the bond market was betting on the Fed as a market participant, not necessarily a steward of the real economy.

Today, the market’s expectations for the FOMC are not as extreme nor as obvious, but the reaction should be telling nonetheless. On the surface, investors are looking for mostly more of the same, with maybe some longer-lasting language. But a whisper is building that Powell may do more. If the Fed "disappoints," and yields climb, it suggests the market is viewing incrementally dovish Fed action not as necessary to the economy, but necessary to markets. It doesn't mean bonds are necessarily in a bubble, but it does mean investors should gear back up for volatility in bonds if the Fed is no longer a reliable new buyer.

Photo by Chris Li on Unsplash