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. There's little question that valuations of potentially risky assets ranging from U.S. junk bonds to property in China and London to tech start-ups are high and that borrowing levels are too. The question is not only whether any of these values reflect mispricings. It's also whether distortions get corrected in a way in which bystanders get hurt. The world economy is still crawling out of the wreckage of the market bubble that popped in 2008.
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. Monetary authorities around the world struggling to revive their still lackluster economies have kept interest rates near zero, or — in the euro bloc, Japan, Switzerland, Sweden and Denmark — below. That's provoked a search for higher yields that has policy makers trying to keep a lid on a trend they are simultaneously helping to fuel. Even traditionally low-risk assets such as U.S. Treasuries and German bunds have arguably entered bubble territory, spurred by those measly or negative interest rates and central bank buying. The European Central Bank is monitoring property prices, but in June also extended its program of boosting the economy through asset purchases to cover corporate bonds. Chinese efforts to rein in property values and lending by so-called shadow banks have been hampered by fear of triggering defaults. As investors forgo any margin of safety to bid up prices higher and higher, the big worry is that the insatiable demand has blinded them to potential dangers that may result in painful losses — especially as the U.S. Federal Reserve considers raising rates.
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 them 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. That's dragged yields on $7.8 trillion of government debt negative; by contrast, the lowest rated corporate bonds have returned 151 percent since 2008, including 9.4 percent this year through mid-June.
One former Fed president, Richard Fisher, once said that stimulus policies acted like “beer goggles,” making normally unappealing assets look tempting to investors under the influence of cheap debt. The low rates have stimulated borrowers, too: companies around the world are more indebted than ever. Some regulators, including Dallas Fed President Robert Kaplan have warned that the impact from a bond selloff may be broadened by exchange-traded funds that track debt markets and are marketed to mom and pop investors. Optimists counter that interest rates aren't about to rocket higher any time soon, meaning issuers and investors can breathe easy for now. Perhaps more importantly, however, the market has weathered a series of tests over the last year — from China's shock devaluation and an August meltdown in stocks, to the Federal Reserve's first-in-a-decade rate hike, the European debt crisis and a spate of volatility connected to slower global growth. There's also evidence some central banks in Asia have found a way to deflate, rather than pop, bubbles via so-called macroprudential policies, holding down property prices, for instance, through measures like tighter restrictions on home loans and higher property taxes.
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.
First published June 5, 2014
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John O'Neil at email@example.com