What If the flight to Security has a Crash Landing?

Could absurd prices, unreasonably low returns and hints of inflation finally burst the bond bubble?

Investors apparently seem to think that America is turning into Japan with long periods of no inflation or even deflation, but what if it isn't?

What if Fed policies designed to stimulate investment and fight deflation succeed enough to create just a small amount of inflation, what happens to bond investors paying through the teeth for inflation adjusted returns of around 1%?

Investors may not trust stocks after the flash crash, but the bigger worry should be bonds. A plunging bond market would erase billions and billions of net worth for Americans overnight.

James Montier, a blogger who works in asset allocation for asset manager GMO, is pointing out that the current state of the bond market resembles other bubbly periods with lemming-like investor behavior.

Last week Reuters reported that he warned a group of financial advisors at a conference in Copenhagen that bonds were no longer a safe investment.

“Everyone loves government bonds at the moment because they have just delivered some incredible 10 year returns, but flows into bond funds are now higher than equity fund flows at the height of the TMT bubble,” he said.

A chart from his blog illustrates his point.

The latest reports from Morningstar confirm this trend continues:

" Taxable-bond funds had solid inflows overall of $20.6 billion, but short-term bond funds have been supplanted in the rankings by world-bond and multisector bond funds, which absorbed $3.7 billion and $3.1 billion, respectively, in October."

According to this article by a director at the research department of Charles Schwab, intermediate bond funds tend to lose 4.5% for every percentage point rise in the fed funds rate. So if rates return to 5% (where they were just three and a half years ago), bond funds would lose about 23% of their value.

While high inflation is admittedly nowhere in sight right now, things could change quickly, after all the US is no stranger to low employment and high inflation caused by say...a spike in commodity prices.

Don't say you weren't warned.