It seems inconceivable there will not eventually be a day of reckoning and there are some who believe the recent volatility afflicting government bonds marks this very juncture.
Short-term movements aside, it should not be forgotten that valuations can remain at apparently ludicrous levels for quite some time; after all, it was nearly five years until Dye was proven correct.
In some cases, being right, but far too early, must be reclassified as just being wrong for a very long time. If this is an investment bubble, it is fair to say that it is the most well recognised mania in investment history.
Bill Gross, who previously managed the world’s biggest bond fund, has described German bunds as the potential “short of a lifetime”. He is not alone.
However, as Sir John Templeton proclaimed, bull markets “die on euphoria”, and it is difficult to find anyone who is euphoric, or even reasonably sanguine about these conditions.
Undoubtedly, there are some who are following the greater fool strategy: I may be a fool to buy eurozone debt but I will be able to sell to an even greater fool further down the road.
That aside, are there any justifications for these valuations?
Certainly, the demand and supply fundamentals of the market are offering some support. With the European Central Bank’s quantitative easing programme now in full flow, it is estimated that the stock of US treasuries, eurozone sovereign bonds and Japanese government bonds will shrink by $800bn (£515.6bn) between 2015 and 2016.
There will also remain demand from certain buyers irrespective of the yields on offer, principally in the financial sector due to ever more stringent solvency regulations.
Breaking point
Meanwhile, the interest rate and inflation backdrop argues against yields moving significantly higher.
The expected interest rate in the euro area in March 2020 is currently less than 0.5% while the risk of a prolonged period of very low inflation, or deflation, remains acute.
Although consumer prices across Europe will rebound and may stay in positive territory in the ‘core’, unemployment remains a significant issue, particularly in the south, and this will continue to exert downward pressure on prices and wages. As a result, expectations of inflation between five and 10 years’ time are still well below the ECB’s target of “close to but below 2%”.
Finally, and in terms of German bunds in particular, financial markets are currently ascribing a 20% risk of a euro area breakup between now and 2020. In this scenario, holders of German bunds could realistically expect to benefit from a meaningful currency appreciation as such bonds are redenominated into newly-constituted Deutschmarks.
It is entirely logical that German bunds therefore trade at a premium to the eurozone average, which goes some way to explaining why a lower percentage of Spanish issues trade on a negative yield compared with their Germany counterparts.
Pulling everything together, it is reasonable to conclude that a bubble does exist in European government bonds. While the market should be underpinned by certain fundamentals – supply, demand, interest rates, inflation – the situation is not as extreme as suggested by yields at their current levels.
Perhaps the biggest danger is that assets which have been felt to offer value purely on the basis of a relative comparison with bonds might not be quite as attractive as these metrics might imply. This would have the added allure of being a mania that is not widely recognised, in comparison to the universal consensus that suggests government bonds are an accident waiting to happen.
As Jeremy Warner at the Telegraph headlined: “Negative interest rates put world on course for biggest mass default in history”.
Betting against the consensus would suggest buying European bonds and selling the region’s equity markets. This would be the contrarian strategy to end all contrarian strategies, although given the recent spike in eurozone yields there is yet the possibility that, this once, the consensus may actually prove correct.
