Economics

How Scary Is the Bond Market?

Mar 16, 2015 Robert J. Shiller

With the bond market appearing ripe for a dramatic correction, many are wondering whether a crash could drag down markets for other long-term assets, such as housing and equities. But when an event has never occurred, it cannot be predicted with any semblance of confidence.

NEW HAVEN – The prices of long-term government bonds have been running very high in recent years (that is, their yields have been very low). In the United States, the 30-year Treasury bond yield reached a record low (since the Federal Reserve series began in 1972) of 2.25% on January 30. The yield on the United Kingdom's 30-year government bond fell to 2.04% on the same day. The Japanese 20-year government bond yielded just 0.87% on January 20.

All of these yields have since moved slightly higher, but they remain exceptionally low. It seems puzzling – and unsustainable – that people would tie up their money for 20 or 30 years to earn little or nothing more than these central banks' 2% target rate for annual inflation. So, with the bond market appearing ripe for a dramatic correction, many are wondering whether a crash could drag down markets for other long-term assets, such as housing and equities.

It is a question that I am repeatedly asked at seminars and conferences. After all, participants in the housing and equity markets set prices with a view to prices in the bond market, so contagion from one long-term market to another seems like a real possibility.

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0 Comments on this paragraph, 21 Comments on this article

Jose araujo Jan 18, 2016

Amazing how founded opinions can helps us explain current situations.

Good to see prof Shiller still being right, while other prophets have been proved wrong.

No bond market rash, actually not even a movement in the other direction, even with FED raising interest rates...

Well, that's not that amazing if you have been paying attention to the right theories...
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Martin Goldberg Aug 1, 2015

The past corrections in the housing markets were comparatively less than what occurred in the US. Past history is no guarantee of future happenings. Unprecedented policy will be met with unprecedented results. Especially in the bond market where there is an unprecedented bubble.
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donald gillies Apr 8, 2015

The mid 1990's is precisely when the govnerment started to under-report inflation statistics. Please make a note of it. http://www.shadowstats.com/alternate_data/inflation-charts
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Edward C D Ingram Mar 23, 2015

None of this measn that it will not happen.

BUT there is a way forward which can contain the foreseen disasters.

I have today decided to create the
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It recommends new debt structures, including one similar to Professor Shiller's idea of bonds linked to GDP, but instead linked to National Average Earnings (NAE) - ideal for pensions that can generate funds that are linked to NAE - defined benefit pensions. Ideal for mutual funds to reduce volatility (50% NAE Bonds) or eliminate it (100% NAE Bonds), and for savings (100% NAE bonds). The market is huge and instantly appealing.

Housing Finance and Commercial Finance will both be refomed based upon similar principles.

In both cases interest rate and inflation rate risk will be contained.

Go forward from there.

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Hugh MacNally Mar 23, 2015

The previous collapse in bond prices might not have been as spectacular as equity market collapses but it lasted 40 years and to quote Burton Malkiel by the 1970s "bond" was a four letter word.

From 1940 through 1980 10 yr yields rose from 2% to over 15%. For the first 15 years investors lost money in real terms and then in the last half they lost in nominal terms. For most of this time the equities market rose strongly and only in the last decade of the bond bear market did it halt to throw off the excessive valuations of the nifty fifty.

It would seem, if history is be repeated, then one won't have too much to fear in stocks as the valuation parameters will keep on rising until they finally get too heavy for even the most entrenched optimists, but that might be 10 years away.
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Andrew Purdy Mar 22, 2015

I am not worried about a crash in government bonds either. There is no way that Central Banks will allow rates to rise very much. A greater worry is in the opposite direction - that nominal rates will go increasingly negative. Nominal negative rates are possible for the first time in history, because most money is electronic now, and cannot be removed from the banking system. Some countries are moving to eliminating paper cash altogether. Since nominal negative rates are unprecedented, we don't really know what dark alleys this leads us down.

Also, while a crash in US government bonds is very unlikely, a crash in corporates is certainly possible. A big downturn in the economy could cause many corporate defaults among those who over leveraged during the upswing.
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Gary Palmero Mar 22, 2015

Bubbles are created when financial leverage (borrowings) is readily available at rates that are perceived to be well under the capital appreciation potential of the asset that will act as collateral. With short rates close to zero and with the ability to borrow in currencies that are depreciating against the dollar (Euros , yen and sterling) thereby creating negative borrowing costs, the temptation may be too great for many speculative players. Leverage can be as low as three percent equity for well appointed borrowers buying Treasuries but even less credit worthy borrowers can use much more leverage against notes and bonds than against equities. Thus, a sharp correction might occur if there is an unforseen major event and this may spill over into other financial markets as leveraged punters attempt to meet margin calls or otherwise liquidate by tossing out everything in sight. If debt instruments are perceived to be money good, then more astute investors will eventually pick up bargains, a la 2009.However, as seasoned investors well know, complacency goeth before the fall. This chapter has yet to be completed. I agree with Dr. Shiller that a bubble collapse is less likely in debt instruments than in dot com stocks or housing because of the nature of the financial instruments which have explicit payouts and the availability of well placed buyers after the turbulence is unleashed but nothing is for certain.
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Gottfried Feyen Mar 22, 2015

Indeed worth noting that the Bond Market has been created such long time ago, that surprisingly in my humble opinion it is still an available product. With the current outlook should it be not redesigned?
Listening and reading all experts attitude it has to be.
Gottfried Feyen
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James Cracknell Mar 22, 2015

Without doubt we are on the brink of another financial crisis that stems from low long term yields. With such low nominal returns risk seeking capital will find its way into unregulated spaces that will eventually cause considerable chaos. It may be the rise of on-line gambling or the growth in last chance entrepreneurship that feeds through into economic instability? Or perhaps the shift of economic power ebbing from Europe and the US to China, India and Asia? - I am not clever enough to predict the ultimate source of any crisis only to say it has to happen. Volatility of capital increases the chances of capital erosion. Actions which shun long term aspirations for short term crisis management shore up weak political systems. No chance of long term survival political vision is truncated to the short term goal based ar0und survival. The bond market may be a scary place but what is scarier is the aftermath of inequality and the break up of social cohesion.
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Jonathan Lam Mar 20, 2015

Gamesmith94134: How Scary Is the Bond Market?
If you can believe the next ten year, inflation would remain in the 2% range and you will gain 0.25% on what your bond paid now; then you would also understand the dollar will also depreciate at a rate the fits the theory. Perhaps, there are deposit charges in banking for the large sum of money now; that no banker can guarantee the outcome on the deposit can sustain the same value or adequate exchange on the currency you deposited, or the bond can be retrieved on a concurrent condition since currency do fluctuate even for dollar.
Perhaps, we look into the current cases in depreciation on Russian ruble and Venezuelan bolivars when the agreement to the exchange on dollar after default. It raised the question on the fiduciary duty of the FED, and IMF that the exchange rate was not equivocally sound since the demand by values on the ruble and bolivars are limited or even lopsided on the scarcity of supply on the dollar. We blamed on the corporate sovereigns distinctively choose creditors over debtors currencies, for which, dollar won its liquidity trap over both rubles and bolivars lost their values from defaults; because the system demands dollar as the primal reserves currency. It is because it had created its hierarchy monetary system that price and value is imbalanced and not guaranteed. It is why many started to contemplate on the equal treatment on the TIPP, TPP and CETA, that is no longer as supply and demand in the exchange system or the currency system; now even the French demands a World Bank's Multilateral Investment Guarantee Agency resolution in dealing with investment funds and sovereign funds in a respective demands.

Based on the CONSUMER PRICE INDEX - JANUARY 2015,
The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.7 percent in January on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index decreased 0.1 percent before seasonal adjustment.
Moreover, the trade association reports that “the average size of purchase loans began to outpace the recovery in home prices in September 2011. By December 2014, according to the group’s weekly mortgage application survey, the average purchase loan amount had risen by nearly 32 percent. The average for the week ending March 6 was $294,900, a record high. In other words, the average purchase loan now exceeds levels reached before the recession when home prices soared to unsustainable heights.”
It gave a chill to the spine that the primal currency reserve like dollar is be devalued by performance and the FED is willing to downgrade dollar for Import –export to bring in revenues for its $483 billion trade deficits. Perhaps, the foreigner or sovereign would wonder if their calculations on the average of the last 18 quarters of inflation and the last 18 quarters of short-term real interest rates are undermined by the low rate and QE; and how much other currencies reserves are available in the FED if demanded.

I am sure US will not be bankrupted, if it can print---fiat money or not; or appreciation of other currency may occur; but TARP does cast a shadow on 2007 in the “too big to fall” theory. Like I said, what if deflation occurs, or all American will inherit all the dollars we printed?

May the Buddha bless you?
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Leo Kolivakis Mar 17, 2015

Professor Shiller is right, a bond-market crash is unlikely but he neglects to mention the real reason why: central banks around the world are all engaged in fighting the titanic battle over deflation:

http://pensionpulse.blogspot.ca/2015/03/how-scary-is-bond-market.html

Best regards,

Leo Kolivakis

Publisher of Pension Pulse blog.
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Iain Henderson Mar 17, 2015

Central Bankers did not predict the crash of 08 while others did. Mr Shiller's PhD dissertation was completed during a period when the USD was pegged to gold, is it possible that as interest rates have basically fallen since then that his assumptions are not relevant in the fiat age? I am not an economist but since 08 have taken a keen interest in economics as my income is derived from investing my capital. As a result of my own research I have little faith in the mainstream economic thinking. It is my opinion that current economic theory has driven the world economy into a ditch and I expect that the next few years may be very unpleasant.
- John Ellis Mar 22, 2015
  
  The world economy isn't in a ditch or equity prices wouldn't be where they are. It was in a ditch in 2008. The US in particular is in many ways in something of a sweet spot. The world has just experienced a particularly bad downswing in the credit cycle. Climbing out of balance sheer recessions takes time. The US and some countries are already well advanced on this path, others less so and it's complicated by the presence of lurking deflation. Schiller is almost certainly correct in his predictions about the low likelihood of a crash in US bond prices (although they're certainly going to fall) but you're welcome to base your investing strategy on some alternative scenario although I wouldn't know what that would be.
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Paul Daley Mar 17, 2015

When interest rates are very low, valuations are very fragile. There really isn't much more one needs say. If there were similar episodes of similarly low interest rates and similarly high valuations, then history might be relevant. But there aren't. People are just relying on central banks to continue support for asset prices, regardless of any adverse impact that support might have on the quality of the capital stock, productivity and inequality.
- Jose araujo Mar 17, 2015
  
  Paul,
  
  Theoric value of a stock goes up when interest rates goes down,nothing strange there. You should expect high valuations when interest rates are low.
  
  On the other side, required rates of return are high because the price of risk went up, but that isn't visible to the naked eye so it tends to be missed.
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Michael Public Mar 16, 2015

Of course you can predict things that have never happened before if you understand the trends underlying the situation. It would appear that there is very little understanding when it comes to current asset prices - only head scratching.
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Jose araujo Mar 16, 2015

Bonds and money are acting has value reserves. For Bonds and money markets to crash something has to fullfill that role, and there is nothing that can do it right now.

When Bonds and money stop acting has the main reserve of value and investors start mobilizing their money, then the economy starts behaving normally, demand grows, employment grows and inflation starts kicking in, and bonds star decreasing.
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arnim holzer Mar 16, 2015

Thank you Dr. Shiller for the analysis. I wonder if a longer term analysis could be done on the relative levels and impact of regulatory policy on economic growth and interest rate levels. Certainly in the very late 1800s tariff and regulatory levels (around fixed currency pegs and trade policy then) were seen as prudent, reduced total GDP growth in the developing economies, and led to relatively low interest rates. As reforms, regulations and trade policies opened up, particularly post WW2, we saw inflation and growth pick-up. Monetary policy squashed the inflation virus in the post 1980s but not the growth impetus. If one looks at the monetary policy undertaken in the last 7 years, one would assume a high resulting nominal GDP. Wouldn't it be a reasonable conclusion to assume that the sharp increase in regulations and overly conservative bank capital requirements is the muting headwind we are experiencing? If contra-cyclical regulatory and capital policy could be undertaken would rates need to be at zero? I think not.
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Craig Hardt Mar 16, 2015

"When an event has never occurred, it cannot be predicted with any semblance of confidence." While this statement may be true, we should not take the logical opposite -- that because something has occurred before we CAN predict it with confidence -- to be true either. The truth is, the future cannot be predicted, but you can use history as a guide for how best to adapt to changing circumstances. The financial crisis showed us that just because something has never happened before doesn't mean that it can't or won't happen in the future. The challenge now is to figure out how to build a financial system that is both resilient to shocks we have seen in the past, and capable of withstanding a shock we haven't seen before. A bond market crash very well could be the "shock" that causes a housing market or other asset price bust, and we should be prepared for this possibility.
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Mike Fellman Mar 16, 2015

Question for Doctor Shiller:
No doubt, the short term interest rate is set exogenously by the monetary authority but is usually influenced by inflation. That is, high inflation or building up inflationary pressures are responded to by the central bank. This makes teasing out effects of central bank policy versus vague notions such as inflation expecations very difficult.

Obviously, in a simple world, it makes sense bond holders would not what to see the value of their cash flows eroded away by inflation. But as I have argued many times, most bond investors have nominal liabilities. Insurance company payouts do not change based on inflation, neither do bank demand deposits. Somewhat surprisingly, it would more risky for an insurance company to invest in TIPS because it would create asset liability mismatch. If inflation undershoots, the real value of TIPS would decline relative to the insurance companies NOMINAL liablities.

My hypothesis therefore is that inflation expectations do not influence bond prices per se. Rather, higher inflation might portend a tightening of monetary policy, which certainly does effect the bond market.

Thoughts?
- Jose araujo Mar 16, 2015
  
  My understanding is that we are living in times where the monetary authority has virtually no controle over interest rates, short-term or long term.
  
  We have been experiencing a fundamental shift in risk perception that pushed riskless interest rates to the zero lower bound, and this without any action form the monetary authorities.
  
  After the financial crisis we saw sovereign debt yelds pushed down into negative territory, even with some countries increasing the reference rates. Investors were taking harbour on bonds, and pushing down rates.
  
  We also have been experiencing a time where the reference rates are near zero, yet comercial interest rates are far from zero, reflecting the diference in the perception of risk of agents and the generalized preference for liquidity.
  
  Regarding your hypothesis, well IMHO, bond prices are like you say prices, and therefore expressed in nominal values, so they have by definition to account for inflation.
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How Scary Is the Bond Market?

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