What Greenspan Gets Wrong -- and Right -- About Bubbles

Corporate debt and German bunds may be the most at risk from a sell-off.

Bond bubbles are unlikely.

Source: Keystone-France

In the 1970s, economists were confronted with the unlikely combination of faster inflation and a weak economy marked by high unemployment. The phenomenon became known as “stagflation.” Former Federal Reserve Chairman Alan Greenspan brought renewed focus to the term when he recently said the economy is moving back into stagflation and that the bond market may be in a bubble about to burst.

Greenspan, however, may have gotten the diagnosis wrong because the opposite is occurring with a twist: Inflation is slowing, but in a sluggish economy with low unemployment. Economists could dub this “stallflation,” as inflation today is being driven by a secular decline in productivity and potential output. 

An economy that grows barely above stall speed isn’t likely to experience inflation like in 1970s that would cause a more serious stagnation or recession. Even if a recession were to occur, it is more likely than not that interest rates may end up falling, refuting Greenspan’s expectation for a return of stagflation that could pop a presumptive bubble in bonds.

The first reason interest rates may stay low is because of the very low neutral rate of interest, which is the level where an economy doesn’t run too hot or too cold. The neutral rate is currently near the federal funds rate, but if the Fed were to continue to tighten policy, the federal funds rate could overshoot the neutral rate. That has historically led to tighter financial conditions and a material economic slowdown that pushed down rates.

Neutral Rate of Interest  

Source: Bloomberg. Neutral rate = Laubach-Williams estimate of the real neutral rate + core PCE y/y%

Secondly, bond markets are suffering from financial repression. Harvard economist Carmen Reinhart defined this as nominal interest rates being held artificially below the rate of inflation by way of financial regulation, caps on interest rates and capital controls. In today’s heavily regulated environment, the incentive to hold government debt by banks, institutions and households is high. As a result, real yields have remained in negative territory globally and nominal rates continue to trend down. 

Global Real Rates and Nominal Rates 

Source: Bloomberg. G20 real rate is based on IMF global GDP weights

A U.S. budget resolution, a debate over the debt ceiling and a potential government shutdown are all coming to a head in the next few months. Markets are worried that the debt ceiling issue may not get resolved in a timely manner, resulting in a technical default. As such, rates on shorter-term Treasury bills have exceeded those on longer-term bills in a phenomenon known as a yield curve inversion, and credit-default swaps tied to Treasuries have jumped. Financial conditions tightened around the 2011 and 2013 debt ceiling events, as budget solutions curbed government spending. The result was that rates fell during and after 2011 and 2013 debt ceiling battles, and this time may be no different.     

U.S. Government Default Risk

Source: Bloomberg. U.S. probability of default = CDS spread / (1-recovery ratio)

So, where to look for the risk of bond bubbles if interest rates are not going to move higher and inflation remains subdued? Bubbles can be spotted by their size, formation and sequence. The chart below shows bonds may have experienced a brief bubble during the early 2000s following the crash in the Nasdaq index of stocks. The bond bubble was followed by a bubble in housing in 2005, oil in 2008 and gold in 2011. History shows that post-bubble, asset values come back at even higher levels than during the bubble.

Serial Bubbles

Source: Bloomberg

That doesn’t mean investors can rest easy. One big risk is if low inflation and slow growth erodes the pricing power of companies, hurting earnings. Another is that stallflation is seen as a better outcome than deflation, providing an incentive to some central banks, such as the European Central Bank, to remove stimulus. In those scenarios, two bond markets that have seen an almost unabated increase in market value would be hurt: U.S. corporate debt and European government securities. A bubble in those markets could reveal itself because high-quality bonds such as those from Apple or the German government trade at exceptional low-risk premiums.  

Greenspan made a better point about asset prices when he spoke at the Fed’s Jackson Hole conference in August 2005. He argued that increases in market values were viewed by market participants as structural, resulting in investors accepting lower compensation for the corresponding risk. He warned that “history has not dealt kindly with the aftermath of protracted low-risk premiums.”  

Although interest rates may stay lower for longer and inflation is not the same as the stagflation of the 1970s, a disproportionate change in corporate bond or European sovereign yields may occur. If so, their “localized” bubbles may adversely affect the global bond markets more broadly.    

Local Bond Bubbles

Source: Bloomberg


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