Sometimes people pay too much for things and they lose money. That’s bad judgment. Other times people pay too much for things and everybody loses money. That’s a bubble. The differences are clear in retrospect, but telling them apart in real time isn’t easy. Right now, for instance, regulators across the globe are warning about inflated prices for potentially risky assets ranging from U.S. junk bonds to the debt of economically shaky countries such as Spain and Greece to real estate in China and London. The question isn’t whether these prices will fall. Many investors agree they will once credit starts to tighten. The questions are how soon, how fast and how far — and how many bystanders get hurt.
What do these assets have in common? They’ve all been buoyed by the easy money made available by central banks since the 2008 global recession. That means that while investors have the most on the line, policy makers may be in the most awkward position. In late May, warnings were sounded by officials at the U.S. Federal Reserve, the Bank of England and in Germany. Regulators worry that investors may be becoming complacent, pouring money into hard-to-sell assets or convincing themselves that they’ve found ways to make risky investments safe. Even Japan’s $1.25 trillion Government Pension Investment Fund, long a conservative bastion, is considering investing in junk bonds. And the market’s appetite for risk has not slowed even as yields sink toward those of safer bets. Normally, central bankers might consider slowing down this kind of party by raising interest rates, but they all have reasons to hold off, such as a weak labor market in the U.S. The European Central Bank is even putting in place new ways to stimulate bank lending in an effort to stave off the threat of deflation, and in China, the government’s efforts to rein in bubbles in property values and shadow banking credit have been hampered by fear of defaults. Instead of cutting rates, central bankers would prefer to use their regulatory powers to squeeze bubbly behavior. The trouble is, the track record of such “macroprudential” tools is mixed at best.
History is full of infamous bubbles: the Dutch tulip mania of the 1630s; the South Sea bubble in England in 1720; mortgage-backed securities in the recent housing boom. In each case, investors bid up prices rather than miss out. When the bubble bursts, the scramble for profits can turn into a scramble for survival, as investors who borrowed to buy have to sell for whatever they can get to cover their debts. Panic sales drive down prices in the same way that manic buying drives it up, and the bankruptcies that follow can spread the pain far and wide. The impetus for high prices this time has been a little different: Investors turned to risky assets not in a mania for huge profits but to avoid anemic returns elsewhere. When central banks dropped interest rates to near zero during the 2008 market meltdown, yields on safe investments like Treasury bills fell close to zero as well. Since 2008, the lowest-rated corporate bonds have posted a 144 percent return, or an annual average of 18.1 percent.
Both those who think we’re near bubble territory and those who don’t agree that the rise in asset prices is connected to the monetary expansion engineered by central banks. One Fed president, Richard Fisher, says stimulus policies are acting like “beer goggles,” making normally unappealing assets look good to investors under the influence of cheap debt. Fed Chair Janet Yellen doesn’t see a bubble in stocks but has noted “reach for yield” behavior in lower-rated corporate bonds. Optimists usually counter with one of three arguments. One is that when companies can borrow so easily, it’s reasonable to rate the risk of default as low. Another is that since economic weakness is likely to persist and may even become a “new normal,” there’s little danger of an interest-rate spike. And, perhaps most importantly, the last few years have been a lesson in when caution doesn’t pay. Fund managers who bet that bonds would lose value have lost money while their peers have done well. That’s kept many would-be bears buying things they consider overpriced by almost every measure — albeit with the nagging feeling that at some point they may regret it.
The Reference Shelf
- A National Bureau of Economic Research paper analyzing bond purchases found that insurance companies that took on higher risks often did not get greater returns.
- A paper published by the Chicago Fed looked at monetary policy’s effect on risk-taking by investors.
- An essay on the reach for yield by A. Gary Shilling, a consultant and Bloomberg View columnist.
- A “Frontline” episode on PBS looked at the history of bubbles.
- A 2010 article in the Economist looked back to the origins of the junk-bond market.
(This QuickTake includes a corrected identification for A. Gary Shilling, the author of a Bloomberg View essay included in the Reference Shelf.)
(First published June 5, 2014)
To contact the writer of this QuickTake:
Lisa Abramowicz in New York at firstname.lastname@example.org
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