April 23, 2014
FiveThirtyEight looks at the bubble horizon and concludes stocks and housing are safe, but we should be worried about bonds. The analysis here is seriously misguided.
First as a sidebar, contrary to what you read at FiveThirtyEight, real house prices are somewhat above, not below, their long-term trend levels. That doesn’t mean we have a housing bubble, but anyone anticipating a future rise in nationwide house prices in excess of inflation is likely to be disappointed.
But the more important point is that the concern about a bubble in bonds is largely illusory. The piece constructs a case for a bond bubble that just is not there.
First, I was surprised to read that the size of the U.S. bond market is almost $40 trillion, which the piece rightly points out is considerably larger than the $28 trillion stock market or the $20 trillion housing market. When I checked the source for this number I discovered that the figure referred to the total size of the debt market, not just longer term debt that we would typically refer to as “bonds.” The FiveThirtyEight figure includes 90-day T-notes and money market funds.
This is not just a question of semantics. Longer term debt (with a duration of five years or more) has large fluctuations in value in response to a change in interest rates. The price of shorter debt will also vary, but the size of the changes is trivial by comparison. This means that if we are worried about a bubble inflating bond prices, we should really only be looking at longer term debt. The size of this market would be roughly half as large, or less than $20 trillion. That’s still big, but a considerably smaller basis for concern than the piece implies.
More importantly, the room for losses in this market is not nearly as large as it was in the case of the stock or housing bubbles. The stock market lost more than half of its value from its 2000 peak to its 2002 trough. House prices lost more than one third of their real value from the 2006 peak to the 2011 trough. By contrast, it is difficult to envision a scenario where the bond market loses even 10 percent of its value.
This can be seen with a simple bond calculator. The interest rate on 30-year mortgages is currently around 4.15 percent. Suppose it were to rise to 5.5 percent, a very large increase. This would imply a drop in the price of a newly issued 30-year mortgage of roughly 19 percent. That is considerably less than the drop in house prices or stock prices seen in the collapse of these bubbles.
Furthermore newly issued 30-year mortgages are a small fraction of bond market debt. Most of the bond debt has maturities of ten years or less. For these bonds the drop in price associated with a comparable rise in interest rates would be less than 10 percent. This could make for some unhappy investors, but would hardly lead to a financial or economic collapse.
In this respect it is worth noting bond prices already did take a very large hit following Bernanke’s famous taper talk last summer. The interest rate on 30-year mortgages rose from less than 3.5 percent in the spring of 2013 to more than 4.5 percent in the summer. If there was any serious stress created by this fall in bond prices, the financial media neglected to mention it. It is unlikely that any future rise in interest rates will lead to as large a drop in prices.
The other evidence mustered in this piece for the bubble case is that spreads have fallen back to pre-crisis levels. Which invites the obvious “so?” And, we see that higher risk debt is increasingly being issued.
This is not the sort of stuff that should cause anyone to lose sleep. The collapse of the stock and housing market bubbles led to recessions because these bubbles were driving the economy. When they burst there was nothing else to replace the demand these bubbles had been generating.
Lower interest rates certainly help the economy, but does anyone believe that investment would freeze up or that housing construction would plummet if the interest rate on long-term debt rose by a percentage point from current levels? In short, the only reason to be concerned about a bubble in the bond market is that influential people are apparently taking the risk seriously and could pressure the Fed to needlessly raise interest rates and cause more unemployment.
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