Surge in bonds and emerging markets fuels bubble

NEW YORK (Reuters) - U.S. government bonds and emerging-market equities have benefited as investors have sought refuge from the housing and credit crises, but the two asset classes' surge in popularity is inflating a dangerous bubble that is likely to burst.

Last year, U.S. Treasuries benefited tremendously from the flight from risk as the credit crisis began. But the sector's popularity took off when the Federal Reserve started cutting interest rates aggressively last September to support the economy. It has reduced its target for the fed funds rate by 2.25 percentage points, to 3 percent.

Short-maturing U.S. Treasuries have returned nearly 7 percent since August, while 10-year Treasury notes have posted returns of over 11 percent, according to Merrill Lynch data.

Not coincidentally, the S&P 500 .SPX, Dow industrial .DJI and Nasdaq Composite .IXIC indexes in 2007 posted their worst annual returns in four years.

Dan Fuss, co-manager of the $16.8 billion Loomis Sayles Bond Fund, sold nearly all of his long-maturing Treasury holdings in recent weeks because he sees more risks than value there.

"Treasuries are in a bubble, in a hot air balloon, and now it is starting to leak," Fuss said.

On Friday, the 30-year Treasury bond fell for a fourth straight day, ending its worst week of losses since early December and pushing its yield to the highest level of the year.

For their part, emerging-market equities, already having posted five years of ample gains, were boosted further by the Fed's rate-cutting moves as investors saw them fueling those faster-growing economies more than any others.

Last year, emerging-market equity funds took in a record $54 billion of net inflows and delivered 36.50 percent in returns.

10-YEAR TRADES AT 30 TIMES EARNINGS

It's not just bond experts who are avoiding bonds.

Legg Mason's Bill Miller, one of the most prominent value stock investors, recently wrote in a letter to investors that government bonds have performed extremely well as the traditional safe haven, but are now "very expensive."

The 10-year Treasury trades at almost 30 times earnings, compared with about 14 times for the S&P 500, Miller noted.

"The two-year Treasury yields under 2 percent, and is thus valued at over 50x earnings!" Miller wrote. "The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it was in favor of Treasuries 20 years ago."

The two-year Treasury note, now yielding 1.90 percent, has a lower yield than the S&P 500, Miller said. "And that is before share repurchases, meaning you can get a greater yield in an index fund than you can in the two-year, and a free long-term call option on growth," he added.

James Picerno, editor of The Capital Spectator, a widely followed markets blog, says "the bond market is like the equivalent of 1999 in stocks," when the technology-heavy Nasdaq climbed more than 85 percent, only to come under harsh downward pressure as credit conditions worsened.

"Remember what happened in 1999? Remember the year after that? Things don't last forever," said Picerno.

But Van Hoisington, president of Hoisington Investment Management in Austin, Texas, whose firm has invested only in long-dated Treasuries, says the United States is facing the greatest "seizing up" of credit since 1930.

"Long-term Treasuries are an unusually good buy here and I would have said that even before the back-up in yields," he told Reuters. "Aggregate demand is visibly weakening to the point of recessionary conditions and we expect them to persist through 2009, suggesting that inflation expectations will diminish greatly over the course of the next 12-24 months."

EMERGING MARKETS AN EMERGING BUBBLE

Investors have also shown strong interest -- in this case again, too much interest -- in emerging-market equities. "They are in the first stages of a building bubble," said Jeffrey Kleintop, chief market strategist at LPL Financial, the largest U.S. independent broker/dealer, in Boston.

The stocks that make up the MSCI Emerging Markets index .MSCIEF are trading at 18 times their earnings for the next 12 months and could sell at over 20 times, Kleintop said.

To be sure, emerging-market economies have been standout performers as their underlying fundamentals have strengthened, owing to the strong demand for their commodities.

Still, Kleintop says emerging markets and commodities, as well as government bonds, are interlinked by another phenomenon: Liquidity.

"The abundance of global liquidity that has been added by the Fed and other central banks to avert a recession may create a speculative bubble in emerging market stocks, commods and long-term bonds," he said.

Proof? Kleintop cites the Baltic Exchange's dry freight Index .BADI, which gauges the strength of seaborne dry commodities trade. It has risen 24 percent since the last week of January.

Picerno sees the growth in liquidity and subsequent inflation threat as harbingers of doom for bonds.

"The peak in the 10-year (note) was 15.84 percent in September 1981 and nobody wanted to own them," he said. "And now with inflationary pressures building, the 10-year Treasury is down at 3.70 percent and you can't mint them fast them enough. It's sort of instructive of how things have changed."