Are we in a bond market bubble?

Watch what's been going on in the bond markets and it's easyto wonder if prices are nearing bubble levels.

American investors have poured almost as much money into bonds in two years as they dumpedinto shares during the internet stock bubble that burst in 2000.

In the two years ended in June, they piled $480 billion US into debt-based mutual funds,close to the $497 billion pumped into funds holding all types of sharesin 1999and 2000.

But not all observers think that bond prices have reached unsustainable highs.

"The reason we can't yet call this a bond bubble is that there are still reasonable explanations for the decline in yields,"Phillips, Hager &North Investment Management said in a recent commentary.

Because yields and prices move in opposite directions, the rush into bonds has pounded yields lower.

In August, the yield on the 10-year U.S. Treasury bond sank to 2.47 per cent, just 39basis points (39/100s of a percentage point) above the most panickypoint in the 2008 credit crisis, and it remains historically low now at a mere 2.6 per cent.

"Market expectations for economic growth have soured and inflation forecasts have declined an ideal climate for bonds," saidPhillips, Hager& North. "Moreover, there is plenty of liquidity searching for a safe harbour, which acts to pull yields down. We are living through an intense period of investor 'de-risking' as assets shift out of [stocks] and into bonds."

Bond prices have also been pushed up as the supply of debt falls, with corporations borrowing less and U.S. consumers paying down their overburdened credit cards and mortgages.

But bond prices have risen to the point where they imply unrealistically gloomy expectations about the economy, according to thePhillips, Hager& North analysis.

'Overly pessimistic'

Over long periods, the inflation-adjusted return on bonds should equal the economic growth rate, meaning 10-year U.S. Treasury yields reflect an expectation for the American economy to grow at an annual 1.5 per cent over the next decade. Given that U.S. growth has averaged 2.5 per cent annually over the past two decades,Phillips, Hager& North described the bond market's outlook as "overly pessimistic."

On that basis, the Royal Bank-ownedinvestment firm argues, now would be the time to look at buying shares. If the U.S. economy returns to historic growth rates over the next few years, it said, "positive returns for today's Treasury investors are unlikely, while equity market returns could easily climb into the double digits."

Acounterpoint tothis comes from Calgary-based Stephen Johnston, who, as president of AgCapita Farmland Investment Partnership, runs a number of inflation-hedging investment funds. Now, he said, is not the time to buy shares.

Johnston sayshigh bond pricesreflect massivepurchases of government debt by central banks that are determined to increase the money supply and devalue their currencies in order to make their countries' exports more competitive.

"They're all in this desperate drive to export their way out of the recession," he said. This should be inflationary, and normally bond prices would fall and commodities would rise as fears of inflation grew.

Inflation hurts lenders, who get paid back in dollars that have less real value than those lent, and encourages the buying of commodities, which tend to hold their real value with inflation.

'The bond market doesn't accuratelysignal inflation anymore.' Stephen Johnston, president of AgCapita

That isn't happening now because the bond market is distorted by the actions of central banks, Johnston said.

"Private sector buying is swamped by public sector buying," he said, "so the bond market doesn't accurately signal inflation anymore."

But in the commodity sector "where the major participants are private sector entities buying and selling ultimately for consumption," he said, "there the inflation signals are extremely strong."

Johnston pointed to the Thomson Reuters/Jefferies CRB index a closely watched barometer of commodity prices which has climbed to two-year highs recently.

It looked like evidence of bond market irrationality on Oct. 25, when the U.S. Treasury auctioned$10 billion in treasury inflation protected securities, or TIPS, at a negative yield. In other words, it seemed that bidders were prepared to pay the U.S. government to own its debt.

But TIPS can be used by investors in combination with other securities to get a return even with a negative yield, by using them as a bet on rising inflation.

And if that means the market is expecting inflation, said Johnston, then buying stocks is not a good idea because share prices may go up, but not enough to account for that inflation. "Historically, equities can perform quite well in periods of inflation and currency devaluation in nominal terms, but most often in real terms, you suffer losses," he said.

At the same time, "bond yields are an artificial construct of the intervention [by central banks in] debt markets. That won't last forever."

Johnston recommended that portfolios have some inflation-hedging hard assets, such as gold, oil or other commodities, but he said investors should be wary of advice to weight their portfolios towards either bonds or equities.

"I would argue that equities may look favourable in relation to bonds. They're both dogs."