Although the peak of an asset bubble is notoriously difficult to predict, it is unlikely that future short-term interest rates will return to their pre-crisis levels of 4–5%, which makes a bond bubble unlikely to occur anytime soon.
How Is This Article Useful to Practitioners?
Bond yields are typically considered to be a forecast of future short-term interest rates, so it is not surprising that recent increases in bond yields have created a buzz in the market about a potential credit bubble. But yields have improved only marginally, and in the case of Germany and Japan, the yields are still below their 2012 levels. In addition, the size of the Bank of Japan’s quantitative easing program is more than sufficient to reduce the bond yields to their previous levels if it wants to do so, thus maintaining the current state of deflation.
The apocalyptic view of government bond markets is that high deficits, in combination with governments’ printing money, will eventually lead to a significant increase in inflation. Although this may transpire in the long run, there are a number of reasons why a credit bubble is not currently a concern. Inflation is expected to continue to fall, spreads are lower than during the previous credit bubble, firms issue bonds to refinance existing debt instead of to gear up the balance sheet, and default rates have reached an all-time low. Overall, it may be a long time until the next credit bubble occurs.
The author provides some contrasting views on why a credit bubble may or may not be likely to happen in the near future. Unfortunately, we cannot predict with certainty which way the credit markets will go.