Where Is the Next Asset Bubble?

Over the past decade, U.S. investors have been whipsawed by three major asset bubbles. First buoyed by overly zealous investors in the 1990s, technology stocks rocketed to levels that will not be matched before most baby boomers are either in a nursing home or dead. As a measure of this euphoria, the NASDAQ index rose above 5,000 in March of 2000. Today that same index is less than 2,000 and shows no signs of returning to those go-go days. Second, housing prices relative to income soared to unprecedented levels from 1995 to 2006. However over the past two plus years, residential housing prices have plummeted yearly by more than 15 percent. Third, oil prices increased to almost $150 per barrel in 2008. Today’s price pressures indicate no quick return to that level even after the economy begins to move out of the recession.

What does each of these “bubbles” have in common? All were fueled by investor’s quest to earn economic returns far beyond what would be characterized as normal. So are there asset bubbles in today’s economy, and will the bubble burst? Yes and yes. The largest and most significant bubbles are in U.S. Treasury long bonds and in the value of the dollar. Over the past two plus years, the yield on the 10-year U.S. Treasury has declined from 5.1 percent to its current level of 3.6 percent. To achieve this plunge, prices of the long bond advanced by more than 40 percent during this same period of time. Global economic fear pushed investors from Beijing to Boston to seek a “safe haven” for their investments. These investors judged U.S. Treasuries as the safest of the havens. Thus massive sales of equities and purchases of U.S. Treasury bonds drove demand and prices for the 10-year U.S. Treasury to levels not seen in more than half a century. To purchase these bonds, international investors exchanged their currency for dollars forcing the dollar to speculative highs.

So when investors assess that economic risks have bottomed and equities are the smart play, they will begin selling the 10-year U.S. Treasury bond and buying equities-both U.S. and non-U.S. This will produce colossal losses for investors that have a significant portion of their wealth tied up in U.S. Treasury long bonds. Of course, a decline in the motivation to buy U.S. Treasury bonds will also result in a plunging U.S. dollar. To borrow from Alan Greenspan, we have, at this time, an irrational exuberance for U.S Treasury bonds which has generated a significantly elevated value of the dollar.

Ernie Goss