The Bewildering Bond Bubble

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Updated 8/13/17
There’s once again more talk about the possible bursting of the bond bubble, mostly initiated by Alan Greenspan .

Here they talk about the gap between the S&P average earnings(inflation adjusted) and the TIPS (An inflation adjusted bond) of about 4.5%. If that gap starts to narrow, then people will go less into the S&P and more into bonds.

‘Inflation and Growth’ tend to have an influence on Bond yields. As long as they’re light, interest rates will stay down. But with inflation expected to start to rise, and the Fed selling off some bonds, the trend is expected to reverse itself this year.

The narrative goes like this: the price of bonds, such as the 10-year note, has been going up for a long time, and it at record highs. This is what people are referring to as the ‘bubble’. But this means that the interest rate on those bonds are going down. They always take opposite directions. The way I think of this is: a bond is a sort of ‘loan’: the government is essentially borrowing money from the person buying the bond. If the loans are in higher demand, that is, lots of people have abundant money to loan out and it’s easy for government to borrow money, then the government can afford to lower the rates it has to pay when it pays back a loan.

If a lot of people want to loan me money, and they’re competing amongst each other to do so, then of course I can start lowering the rate I’m willing to pay to get the best loan.

Similarly, if money were in short supply, and it’s hard to get a loan, then of course lenders will want a higher rate for the loan. And this is why the two quantities travel in opposite directions.

These two nice videos from the Khan Academy explain it more quantitatively: Bond prices and interest rates and Bond prices and rates take two .

The best example I’ve seen is that of a $1000 two year zero-coupon bond which, at a rate of 10%, would have to sell for $826 (since if you take 10% of 826, and then take 10% of the result, you’ll get 1000). However, if the rates went up to 15%, the price would have to go down to $756. And if you paid the paltry rate of 5%, you’d have to sell the bond at $927 in order to make $1000 at maturity.

Apparently one of the reasons people are worrying about bond interest rates going up, is because the Federal Reserve is selling some of the bonds they had bought during the recession (which is called Quantitative Easing, or QE). Since they’re reducing their ‘balance sheet’ of bonds, and putting more of them on the market, by supply and demand, the price of these bonds will go down, and hence, interest rates will go up.

This means that many investors who were into stocks will exit in favor of getting better rates in bonds (a lot of people keep a mix). So if this happens too rapidly or intensely, we could have a quick drop in the market – a sort of ‘crash’. That’s the essence of what people are afraid of regarding the Bond Bubble.

Here’s a contrarian view , from Matthew Graham, chief of operations at mortgagenewsdaily.com.

He’s claiming that essentially the Fed won’t reduce its balance sheet by too much, so there’s no danger of shocking the system. Also, he’s saying that the rate increases and reduction are already expected by investors, and priced into the system.

I guess the upshot is whether there is a gradual reversal, or a sudden, market shocking change that hurts investors, and I don’t think anyone truly knows for sure.


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