Forever blowing bubbles
In March 2000 the NASDAQ Composite index broke. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite had slumped to half that by the end of the year.
The bursting of the dot com bubble sent unemployment shooting up from less than 4 percent in late 2000 to 5.75 percent in late 2001. And it stayed there. Indeed, American unemployment didn’t peak until mid 2003 when it hit 6.25 percent.
As unemployment refused to budge and inflation slowed in early 2001 Alan Greenspan acted. Between January 2001 and June 2003 Greenspan slashed the Fed funds rate from 6.5 percent to 1 percent where it stayed until June 2004.
The effects are well known. With the economic foundations in place for an asset boom, institutional factors took over to decide which asset would do the booming. In this case government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, combined to direct the flood of credit into housing.
All booms and busts follow this pattern. An expansion of credit unsupported by real savings provides an economic base for a boom bust cycle and the institutional superstructure dictates which asset or assets will be the locus.
Since the credit crunch of 2007, and especially since the collapse of Lehman Brothers in 2008, central banks around the world have indulged in a massive expansion of credit not backed by savings. This looks very much like the foundation for another boom bust cycle. Where will it originate?
The trick is to follow the money and this means examining the institutional factors. Central banks have pumped their money into banks, who have sat on it, and, via Operation Twist, the EFSF, Quantitative Easing, or whatever, into government bonds. Is this where we will see the next bubble?
Let’s take a moment to explain how bonds work. If I want to borrow £100 I can issue a £100 bond with a maturity of one year, meaning that a year from now I will have to pay the buyer of the bond £100.
But I am unlikely to be loaned the full £100 by the person who buys the bond. If they did they would be giving me £100 now in return for £100 365 days from now. But to a buyer these two things, £100 now and £100 next year, are not the same.
The reason for this is time preference which is the basis of interest. If you are offered £100 which you can have today or £100 which you can have next year (the situation our lender is in) time preference dictates that you will prefer to get the £100 today. In other words, even though £100 is £100, time has a value so that the same thing offered at different points in time will be valued differently.
Put simply, something today is valued higher than the same thing at some future point. A bird in the hand is worth two in the bush, as they say.
To offset your preference for the £100 today over the £100 next year I would need to change the offer so that you give me £100 now and I repay £105 next year. An interest rate of 5 percent has emerged.
So if you issue a £100 bond you might only get £95 for it, this being the bond price. But you will still have to hand over £100 on maturity; the £5 difference is the interest, or the yield in bond market parlance. (The yield would be given as 5.26 percent as it would be a percentage of the bond price not its face value)
From this it should be obvious that bond prices and yields move in opposite directions. If the price rose to £96 the yield would fall to £4 (4.16 percent) and if the price fell to £94 the yield would rise to £6 (6.38 percent). In some cases bond prices can rise above face value giving a negative yield, meaning that lenders are paying for the privilege of lending.
Bonds prices are subject to the same supply and demand pressures as any other. So when demand rises/supply falls we will see higher prices and lower yields, and when supply rises/demand falls we will see lower prices and higher yields.
Let’s step back into the real world. Greek bond yields are high because few believe they will get the face value on maturity which, given Greece’s hideous debt problems, is a reasonable assessment. There is little appetite for Greek bonds and, with budget deficits of 8 percent of GDP, there is plenty of debt for sale. Germany, meanwhile, has a relatively sounder economic outlook and low (even negative) yields.
But Britain has Greek levels of debt and German interest rates, a new bond market conundrum. One reason is that of the vast expansion of credit undertaken by the Bank of England since at least 2008 much has flowed into British government bonds. Currently the Bank holds about 25 to 30 percent of British government debt.
A bubble is where asset valuations become divorced from the fundamentals of that asset’s ability to produce a return. A government with sound finances backed by a robust economy should enjoy low bond yields. But does this sound like Britain’s government or economy?
By pumping bond prices up and yields down this monetary action has helped inflate a bubble in bonds just as surely as previous credit expansions have inflated other bubbles.
Is the bond bubble the biggest yet?
This article originally appeared at The Commentator