Michael Brandl > Macro Updates > Archives > June 1, 2003

July 1, 2003

Is there an asset bubble in the bond market?  With bond yields being at 45 year low some have suggested that there is an asset bubble in the bond market.  The argument goes that money has flowed into the bond market, pushing up bond prices, and thus pushing bond yields lower.  This is not sustainable the argument goes.  These “high prices” are signs of an asset bubble and, as we all know, asset bubbles burst.  Thus, it is argued, bonds prices will fall soon.

 Is this true?  I’m not so sure.  First off, let’s not be so quick to label all asset price increases as yet another "asset bubble."  Asset bubbles are irrational, illogical, run ups in the price of an asset.  Often asset bubbles are driven by the “Greater Fool Theory.”  That is, I will buy an asset (tulip bulbs, dot.com stocks, real estate, etc.) simply because I think there is some bigger idiot out there who will buy it from me at a higher price.  Why do I think the price will increase?  The answer that is often given in bubbles:  because the price has increased in the past.  This type of thinking is what drives asset bubbles.

The bond market is something different, I think.  What you are seeing in the bond market are a couple of things.  First, there is a lot of cash in the market.  A lack of IPOs, not much M&A activity, firms not undertaking capital expenditures, etc. so the market is awash in cash.  A lot of people are “sitting on the sidelines” if you will, not willing to get into other markets and projects.  So…if you have cash, where do you go?  Into the nice, (relatively) safe bond market.  So, yes, money has flowed into the bond market.  But is it irrational?  Well…not in the asset-bubble sense of the word.

Second, you have the Fed.  I believe the Fed is interested in seeing lower interest rates, not just short-term rates but lower long-term rates as well.  If the Greenspan Fed can push long term rates down to where they were in the 1950’s, they could claim that they have finally put the inflation genie back into it’s bottle.  The war against inflation, that started with Paul Volcker in 1979, will finally be over.  What a legacy for the Greenspan Fed to leave.  Of course, this policy approach is not without risk.  More about that later.

So is it an asset bubble?  I don’t think so.  Does that mean bond prices and yields will stay where they are?  Well…no.  I think bond prices will fall, and yields will increase, as signs of a strengthening economy become clearer.  Money will move out of the bond market, prices will fall and yields will increase, but I doubt that it will be a free fall in prices that one typically sees with the collapse of an asset bubble.

Talk of asset bubbles in the bond market makes for great shock value in media reports.  Reality, however, is a little more boring.

Speaking of an economic recovery…the Fed’s Open Market Committee last week voted to cut it’s target of the Fed Funds Rate by a quarter point.  A number of Fed watchers, as well as the futures market, were thinking a half point cut was possible.  Others, including some at the Fed, worried that there is already enough stimulus in the pipeline and any cut in rates would risk inflation in the future.  The FOMC decided to take the middle road and cut rates by a quarter point. 

In their statement the FOMC basically said that the economy looks to be stabilizing and ready to grow, but a cut in rates may be necessary to fend off any deflationary pressures.  Note:  the Fed did NOT use the “d-word” but the intent was clear. In addition, the Fed pointed to weak labor markets and weak capital spending by firms as proof that “the economy, nonetheless, has yet to exhibit sustainable growth." 

So what next?  I think this will be the last reduction in short-term rates coming from the Fed.  If the economy fails to pick up in the second half of the year watch for the Fed to work its way down the yield curve and take aim at the medium to long term bond yields.  This could be very controversial, but consistent with what the Fed has been saying publicly.  The general consensus is, however, that this will not be necessary.  Most economists who watch such things, are predicting the economy to pick up in the second half of the year.