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© 2017 by Coastwise Capital Group, LLC 

The B-Bubble

December 19, 2017

When people think of bubbles these days, they invariably turn to Bitcoin which has indeed increased an astounding 1,600%+ in under 12 months.  As this is a new currency with little to no basis to value it (as compared to a stock which can be valued based on various metrics including discounted cash flow), we will only know well after the fact if today’s prices represented a bubble or the buying opportunity of a lifetime (more likely the former than the latter, but stranger things have happened in the world of finance…..see below).

 

The real bubble may actually exist in something far more mundane than headline grabbing crypto currencies.  I’m talking about a centuries old financial instrument called… drum roll please… a bond.  That’s right, the time tested, ‘safe’ security entered unchartered territory recently when a staggering 5+ trillion (yes trillion with a “T”) dollars’ (or Euros or other currencies) worth of negative interest bonds were sold.  Not low interest rate bonds (many of which also exist and which could get hit hard in a rising rate environment), but negative.  All it would take is for interest rates to return to where they have resided for the other 99.99% of history – positive – for the losses to start rolling in.  Investors buying negative interest rate bonds, which by definition lose money if held to maturity, may make Bitcoin speculators look conservative.

 

If the price of Bitcoin went to zero, a couple hundred billion dollars would disappear.  Not a small number, but easily absorbable by our global financial system. Yet a small percentage increase in bond rates could wipe out many times this in wealth, not from gambling types speculating on the latest wild Bitcoin price swings, but on pensions, retirees, and other savers who can ill afford to take such a hit.  A material increase in interest rates could make the internet dot com bubble burst seem small by comparison.

 

I’m not suggesting such an event is around the corner nor would it likely occur ‘overnight’ like the stock market crash of 1987.  Interest rates tend to move more slowly than the price of stocks. But witness the relatively short period just a few years ago when the US 10-year treasury rate increased from around 2% to 3%, causing double digit losses in those widely held securities.  Now imagine if trillions of dollars in negative interest rate bonds saw their yields turn positive and head north.  While not as sexy as the latest internet stock crashing and burning, or the story of some taxi driver who made and then lost millions betting on Bitcoin futures, the impacts felt by a real bond bear market could cause material financial turmoil.

 

As the saying goes, be careful what you wish for.  The US and other developed counties could experience a Japan like scenario where interest rates stayed near zero for nearly 2 decades.  Or, with all the monetary (via the Fed), fiscal (think big tax cuts), and other stimuli (Trump is calling again for massive spending on infrastructure) fueling a rebound in world economies, a spike in interest rates in the coming years is not out of the question.  Picture an auditorium full of thousands of people and only a few dozen chairs.  Then the music stops.  That could be the scene as investors realize the tide has turned and they start trying to sell their bonds – fast (not to mention governmental banks like the Fed selling at the same time as they try to unwind quantitative easing to rationalize their balance sheets).

 

If you are not certain whether your portfolio contains potential hidden time bombs (just like a stock wasn’t a stock wasn’t a stock in the late 1990s with internet companies crashing while value stocks held up just fine, a bond isn’t a bond isn’t a bond… and how you are allocated to this asset class could have a big impact on your financial future 5–10 years from now) seek the advice of a professional who can help you navigate this potential mine field.

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