The Bond Paradox

In previous posts, I’ve been discussing the fact that by historical standards real estate is at near all time peak yield levels but that the yield gap compared to government bonds is making current real estate yields look like good value.    John Authers has a piece in the FT today making broadly the same point about the relative pricing of stocks and bonds.  If you replace stocks with real estate , the issues are basically the same

Look at the chart of the S&P and this looks like a peak, and a bad time to buy. Look at the chart of how stocks have performed relative to bonds, and it looks like stocks should be ready to shine. This illustrates the paradox that has also lasted for years that stocks look expensive by almost any sensible historical measure — except when compared to bonds, when they look cheap.

But there is a nasty problem with this. If bonds finally go into reverse, rates will rise, the support for stocks will be removed and the risk is more that stocks will start to fall. The bond market rally is extraordinary, it has gone on for a long time, defeating predictions by many (myself included) that yields had become unsustainable. US Treasury yields have been falling steadily for more than three decades.

If bonds can somehow continue this, then stocks will probably continue to prosper (although they may fail to outstrip bonds). If bonds go into reverse, it would be bad news for both stocks and bonds. And either way, the record in the S&P 500, which has created genuine wealth for those who hold it, is a sideshow besides what is happening in bond markets.

Bill Clinton’s political adviser James Carville famously said that “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” The big ‘if’ is what happens to in the bond markets. John Authers has not been alone in predicting bond yields to rise as they’ve continued to fall. It’s the key question.  If this is what Japanese style secular stagnation looks like, the lessons are fairly clear.  10 year government bond yields haven’t been above 2% in Japan for almost 20 years – albeit 2% seems a heady figure compared to the fact that they’re now in negative territory.  Could long term bond yields under 1% be the new normal?  If so, it could mean commercial real estate yields continuing to fall.  It’s not a sideshow if you’re a real estate investor.

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