Monday, November 18, 2013

The Bond Bubble (excerpt)

Presumably, among the risks of QE are speculative debt-financed asset bubbles. However, last week, Janet Yellen said, “At this point, I don't see a risk to financial stability, although there are limited signs of a reach for yield.” She said that based on current valuations, stocks aren’t “in territory that suggest bubble-like conditions.”

I see more bubble-like conditions than Janet Yellen does. Her lack of concern may be justified currently, but by expressing it she increases the odds of triggering melt-ups in asset markets, especially if she turns out to be even more dovish than Bernanke, as I expect. Consider the following:

(1) Emerging market debt. The result of the widespread “reach for yield” is that debt sales by emerging markets rose to $439 billion this year through October, within reach of last year’s record of $488 billion. According to the 11/6 FT article on this subject, “record debt sales from the developing world have rebounded after a summer of turmoil and the US budget crisis stunted demand, leading analysts and bankers to predict the second record year of bond issuance in a row.” Tapering chatter during the summer nearly burst the bubble in emerging market debt. Since the 9/18 decision not to taper, more air has been pumped into it.

(2) Corporate bonds. The Fed’s Flow of Funds data show that the outstanding amount of corporate bonds issued by nonfinancial corporations rose to a record $6.1 trillion at the end of Q2-2013. That’s up by a record $625 billion y/y. That may not seem like a bubble since corporations may be using some of the proceeds to reduce their short-term debts, and have lots of liquid assets. However, corporations also are likely to be using some of their bond proceeds to buy back shares, which artificially inflates earnings per share. That’s a bubble-like development if stock prices are getting a significant lift from debt-financed share buybacks rather than actual earnings growth.

Today's Morning Briefing: Party On, Dudes! (1) Yellen and Gatsby. (2) Yellen is in no rush to taper. (3) Benefits outweigh the costs of QE for now, she said. (4) No bubble in stocks, she said. (5) Bull following lead of FOMC’s doves. (6) Record bond issuance as investors reach for yield. (7) Yellen’s first press conference on March 19 should be bullish. (8) Yellen may have to nurse economy from Obamacare disaster. (9) Yellen stocks. (10) “Dallas Buyers Club” (+ +). (More for subscribers.)

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