Beware the next bubble - bonds

In the beginning, there was a Nasdaq bubble. When the air went rushing out of it, a housing bubble formed, a symptom of a much larger bubble in credit, which in turn helped inflate (arguably) new bubbles in the emerging markets, in oil, and in other commodities.

Pop, pop, pop, pop. Can there possibly be any bubbles left after Meltdown 2008? Only one, maybe: Government debt. In 2009, it could be swept away, too.

"The bond market's going to collapse," warns Peter Schiff, president of Euro Pacific Capital, a brokerage firm based in Connecticut. He's one of a small number of financial pros who called the plunge in U.S. real estate prices before it happened; now he's forecasting the same for U.S. Treasuries. "It's the biggest bubble yet to burst. It is a complete fantasy."

That's the sort of cheery New Year's forecast you might expect from a man nicknamed Dr. Doom. But Mr. Schiff has important company in the bearish camp. Pimco, the Newport Beach, Calif., giant that manages some $800-billion (U.S.) in bonds, has also grown negative on U.S. government debt, especially long-term debt. With 30-year Treasuries yielding barely 3 per cent, the rewards hardly seem worth the risk, Pimco's managers are saying - unless you believe U.S. inflation will be close to nil over the next three decades. Not too likely.

In Canada, the bond bargain is not much better. Yes, this country is in superior financial shape. While the Bush Republicans were adding nearly $5-trillion to the U.S. federal debt, Ottawa was accumulating surpluses. Canada's ratio of net debt to GDP is now about half of America's - the lowest, in fact, in the G7. It's hard to believe for those who recall The Wall Street Journal's 1995 slur making Canada an "honorary member of the Third World," but for the first time, a triple-A credit rating fits Canada better than the U.S. All of which is nice, but not what really matters to the saver and investor.

What matters is price. A Canadian buyer of 10-year federal debt today accepts a return on his money, before inflation, of 2.88 per cent (down from about 4 per cent at the time of the last federal budget in February). That is to say, he's making a bet that inflation will be substantially below 2.88 per cent between now and 2019.

What are the odds of that? Assume, given the low risk of a crisis in government finance in Canada, you'd be content to earn a 2-per-cent real return (i.e., after inflation). It's not much, but at least safe, right?

To get that, inflation would have to be less than 0.89 per cent a year over the next decade. But since the end of the Second World War, this has never happened. The closest was in the 1950s, a rare period of growth with extremely stable prices: from 1951 through '61, inflation averaged just 0.94 per cent annually. (Before that, you have to go back to the Great Depression, when deflation ruled.) Not only that, the Bank of Canada's goal is inflation of at least 1 per cent.

At least the central bank has an explicit upper limit of 3 per cent. The U.S. Federal Reserve does not, and through history it has been every bit as willing to debase the currency in the name of economic growth as has Canada's central bank. Over the past 60 years, the U.S. buck has lost about 89 per cent of its purchasing power. "Even if somebody wants to say we're going to have low inflation for the next year or two, can anybody really say that [with]this most inflationary monetary policy in the history of this country, that people are going to be able to buy a bond for 30 years and clip a 3-per-cent coupon [and come out ahead]" Mr. Schiff asks. "Does anybody believe that?"

Well, apparently somebody does, or bond yields never would have fallen this low, this quickly. There are two possibilities. The first is that the collective wisdom of the bond market really does see another prolonged depression, with deflation to accompany it.

The other is that bond prices have been driven up (and yields down) by short-term factors. In other words, most investors can see government bonds are too expensive, given the deteriorating shape of public finances - just as Amazon.com was absurdly priced in 1999 and bungalows in Phoenix were in 2005. But now, as then, they expect they'll be able to flip them at an even higher price to someone who's dumber than they are.

"I think what we should know by now is that we can't put any faith in what happens in the short run. Internet stocks went way up. Does that validate anything? No. They collapsed to zero," says Mr. Schiff. When it comes to U.S. Treasuries, "nobody is intending to hold to maturity. Everybody thinks they're going to get out the door in time." That's the greater fool theory at work, and it's the very definition of a bubble. Beware, all those who would seek shelter in supposedly ultra-safe bonds.