Is there a bubble in the bond market?

The historically low yields on Treasury bonds are the hallmark of a bubble, according to some commentators. This column analyses the relationship between bond yields, the stock market, and inflation over the past 50 years. It finds that the riskiness of nominal bonds changes over time and that investors and policymakers can use the changing stock-bond correlation as a real-time measure of inflation expectations.

The yields on government bonds are at their lowest levels since the depths of the financial crisis in late 2008. On Monday 18 October, the yield on 10-year Treasury notes hit 2.52%, down from 3.85% at the beginning of the year. This movement is huge by the standards of the Treasury market. An investment in 10-year Treasury notes has returned about 11.4% this year.

Moreover, nominal bonds are exposed to inflation risk. Given that the use of unconventional monetary policy has increased uncertainty about inflation (e.g. Taylor 2009), one might expect investors to regard bonds as particularly risky and demand high yields (low prices). The persistence of historically low yields in the face of such risks has led some commentators, notably Siegel and Schwarz (2010), to suggest there is a bubble in the government bond market.

Bond valuation and risk

What determines how much investors are willing to pay for nominal bonds? There are three critical factors:

* expected inflation,
* real interest rates, and
* risk premia.