Bonds may not be in a bubble, but they're due for a big fall

MarketWatch (MCT) - Despite some recent claims to the contrary, the incredible rally in Treasury bonds over the last year is not forming a bubble.

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But T-Bonds nevertheless are a poor bet for the long term.

These at least are the conclusions reached by Dan Seiver, a visiting finance professor at San Diego State University and editor of an investment newsletter called the PAD System Report. Seiver squeezed in an interview Dec. 11, despite it being the last day of the semester for the three classes he was teaching.

The reason Seiver doesn't believe bonds are forming a bubble is that the bond market is not rallying because of greed. He argues that greed is a key distinguishing characteristic of investment bubbles _ whether of the Internet bubble of the late 1990s or tulip bulb mania in the 1600s.

In contrast, Seiver points out, bonds are rallying out of fear: Investors are so scared that companies will become insolvent that they are not only unwilling to invest in them, they aren't even willing to lend them money.

All this said, however, Seiver nevertheless believes that long-term bonds are a very poor bet right now. "The chances of achieving capital gains from buying long-term bonds right now are extremely low," he said.

Seiver bases the confidence with which he makes this forecast on the likely future course of inflation. Right now, for example, the 30-year Treasury bond is yielding just 3.09 percent, according to the CBOE's 30-year T-Bond yield index. Seiver believes that average inflation over the next 30 years will quite likely be at least 3.1 percent, providing T-Bond owners with a zero real return before taxes.

T-bond rates will surely rise as investors realize this. And when that happens, of course, T-Bond prices will correspondingly fall.

In support of Seiver's argument, I note that the Consumer Price Index over the last 30 years has risen at an annualized rate of 4.05 percent, nearly one percentage point per year higher than the current 30-year T-Bond yield. In effect, therefore, an investor buying the 30-year T-Bond right now is betting that inflation over the next 30 years will be much less than what it has been over the last 30 years.

Put that way, of course, the bet certainly seems to be a poor one.

The same conclusion is reached if we focus on 10-year T-Notes, by the way, whose current yield is 2.65 percent. Over the last 10 years, in contrast, the CPI has risen at an annualized rate of 2.95 percent. So even if you are purchasing a 10-year Treasury rather than the 30-year, you are betting that inflation in the future will be significantly lower than in the past.

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What about a full-scale depression, which some who are advocating the purchase of 30-year T-Bonds believe to be likely? Though Seiver doesn't believe that such a downturn is in the cards, he said he still wouldn't invest in T-Bonds even if he thought a depression were likely. That's because the Federal government's finances are in such a shambles that its credit rating would probably be cut sharply during a full-scale depression. In that event, Seiver argued, even though T-Bond rates wouldn't be rising because of greater inflation expectations, they would still rise _ because of the Federal government's lower credit rating.

What about the high probability that the Federal Reserve will cut interest rates in coming months? Once again, Seiver doesn't believe that's a good reason to buy long-term T-Bonds. The Fed can cut only short-term rates, and Seiver said it's plausible that long-term rates would rise in the face of further cutting of short-term rates.

The bottom line? Seiver believes that the bond market is artificially high right now (and long-term yields artificially low) because of the market-wide flight to quality. Holders of long-term bonds therefore should take the opportunity to get out.

Seiver also had some parting advice for the U.S. Treasury: It should refinance a chunk of its short-term debt as possible with 30-year T-Bonds. "What a deal the market is giving the Treasury," Seiver argued: "It can lock up money for 30 years at 3.1 percent, even though the inflationary consequences of its actions will in large part be responsible for why that 3.1 percent will be an incredibly bad deal for investors who buy the bonds."

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(Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. He can be reached at mhulbert@marketwatch.com.)

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