1. You could have earned a lot of money in bonds by following Krugman's analysis during last four years. Bond market is clearly not incorporating and reflecting the very public information from Krugman's blog in a timely manner, this means that the Efficient Market Hypothesis (EMH) is false for government bonds.
2. Rober Shiller has shown that volatility of stocks is much larger than can be explained by the news about economic fundamentals. The same applies to bonds; they are too volatile, with bubbles and anti-bubbles forming.
3. In early 2010, bonds were in the anti-bubble territory. Investors were overestimating the probability that the recovery will remain on the V shaped track. You should be allowed to talk about bond bubble only if you said bonds were cheap in early 2010, otherwise you should be using EMH.
4. Krugman has a model that says 10-year bond is trading at the right price now. The problem is that Krugman is assuming that the only tool Fed will use is zero interest rates. There is approximately 20% probability that Fed will do the right thing by restarting aggressive quantitative easing and credit easing as suggested by Bernanke in 2003. Bond market is ignoring this possibility and 10-year bond is already overpriced.
5. Many economists think that bubbles are harmful and that the Fed should actively lean against the bubbles. Well, the bond bubble is also very harmful, as bonds are pricing in extended unemployment and below-trend inflation. Bernanke should print more money ASAP in order to burst the bond bubble.
6. Fiscal stimulus can also successfully deflate the bond bubble. Tax cuts that can be reversed in the future cause no significant long term fiscal damage while stimulating the economy, healing the private sector balance sheets and containing the growth of the bond bubble.
7. Noise traders are a key source of stock market inefficiency. They are a big problem for bond market too. As asset maturities get shorter, the noise trader risk is diminished, and the short end of the bond market is pretty efficient. This means that we can rely more on the prices of short term treasuries when formulating public policy. Temporary tax cuts are a no-brainer, while it is much harder to reliably measure the NPV of infrastructure investments with long payback periods.
There are a lot of trend-following momentum players in bonds, and a fall in Treasury bond prices would certainly induce further selling.
8. The most important noise trader in the interest rate markets is China. Authorities are pushing for a much higher level of the savings than can be justified by the preferences of the Chinese people.
9. Every bubble has faulty valuation models. There is no exception now, as we have Gluskin Sheff's David Rosenberg:
"Well, the Fed just told us that it has no intention of hiking rates for a long, long time. So, Fed tightening risks are off the table and at a time when the policy rate is almost zero. And we have a long bond yield of 3.6%. That is a 360 basis point curve from overnight to 30 years, and historically, that spread averages out to be 200bps.10. Every bubble has excessive trader sentiment, here is David Rosenberg again:
As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached. If we are right on -1% to -2% deflation in coming years as the post-bubble excesses continue to unwind, nominal yield will actually be quite juicy in “real” terms."
"We have also been hearing that bullish sentiment towards Treasuries is now 98%, according to some surveys, approaching the incredible 99% on December 16, 2008, right as yields were plunging to their trough (the 10-year note approaching 2%). <..>
At the Grant’s Conference in April, Jim labeled the event we closed down together on stage as “Bonds are for losers.” Even in June, the Barron’s poll showed the vast majority of forecasters calling for higher yield activity. Now every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old shop who are now broadly filled with perma-bulls (now are calling for a 2.5% yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel."