Since around 2009, monetary authorities around the world have been keeping interest rates extremely low (near to zero) in order to stimulate economic growth.
Low interest rates mean that it is cheaper for people (including businesses and governments) to borrow money.
This sounds like a great thing. Why do we not always keep interest rates low in order to facilitate this?
The problem is with inflation. Having long terms of low interest rates will cause our currency to appreciate as more people have more money to spend.
When interest rates are high, people tend to save more than they would otherwise because the returns to saving are higher, meaning that there is less money available to invest.
This sounds like a bad thing, but everything has pros and cons. It all is a delicate balance that needs to support both saving and investing habits in the long term.
So how does this affect bonds?
We know that bonds and interest rates are related. The higher the interest rate, the less that the market value of issued bonds will be since other investment opportunities will arise that are more attractive than bonds that were issued at a point in time when interest rates were lower.
When the interest rate is lowered, bonds that have already been issued will raise in market value because they offer a higher yield than what is currently available.
What is a bubble?
A “bubble” is essentially an economic cycle that consists of an acceleration of value within an asset class followed quickly by a contraction.
The housing bubble that played an essential role in the Global Financial Crisis has been attributed in part (by many) to the FED keeping interest rates so low. Low interest rates encourage reckless behavior among firms and financial institutions.
There is a clear link between interest rates and inflated housing prices and this report by the Federal Reserve states:
“Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission”
More cash on hand facilitates less conservative practices with money, and low interest rates encourage certain assets to rise in value indefinitely, but only up to a point.
At some point, a major market correction will occur where people begin to lose confidence in a certain asset. Up until this point, the asset in question has maintained a market price that exceeds the inherent (or real) value of the underlying.
Former Federal Reserve chairman Alan Greenspan famously characterized these inflated prices as “irrational exuberance” in prediction of the .com bubble burst.
People get caught up in the game of buying and selling where market trends convince them that they can continue to sell an asset at a higher price than they bought it.
Interest rates have been so low for so long that Bonds have become an incredibly attractive option to investors.
Alan Greenspan, who was the Federal Reserve chairman during the Global Financial Crisis has spoken about how the interest rates have been at rock bottom for so long that they have created another bubble, this time in bonds.
He predicts that the inevitability of rising interest rates will cause the market price of bonds (which he claims is artificially hight) to decrease. Given the strength of the bond market, this would happen quickly and severely.
Though it would not be a frenzied exit from a collapsing market, the volume of assets that would be moved at this point would cause an effect near enough to frenzy that it concerns enough people.
Greenspan claims not to be able to predict when such an event would happen, and that anyone who claims to be able to is delusional.
He knows though that the market will look its strongest right before the collapse.
So is this really the case? Let’s look at the flip side of this argument… in the next article.