Arnold Kling  

More Bond Bubble Talk

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At The Economist, pointer from Tyler Cowen.

Laurence Kotlikoff writes,

current bondholders will get hurt in two ways. The prices of their bonds will fall due to concern about future money creation and the current price level will jump due to past money creation.

Read the whole thing. Keep in mind that Kotlikoff has a propensity to stake out positions far from the mainstream. You will see that most of the other participants in the forum are not inclined to believe that there is a bond bubble.

Tyler Cowen is judicious, as usual.

More often than not, market prices are right and probably interest rates will not soar anytime soon, just as they did not soar in 2004. Still, there is some risk that market interest rates are wrong.

A bubble usually incorporates a story or mantra that investors recite on the way up. The mantra of the Dotcom bubble was that first-mover advantages and network effects were a new source of wealth. The mantra of the housing bubble was that house prices never decline on a broad national level.

For the bond market, there are two perspectives. One is macroeconomic, and with the outlook as weak as far as the eye can see, low interest rates seem reasonable. Look, we could all be surprised and economic growth could be really strong 12 months from now. But I don't see the weak-economy story as a mantra that people are mindlessly reciting.

The other perspective is the potential for a sovereign debt crisis. Here, I worry that there is a mantra, which is that "there is no reason to worry about a default when a country's debt is denominated in its own currency." If you're inclined to recite that mantra, then you need to read Kotlikoff.

One thought that occurs to me is that the Fed may be in an awkward position right now. A lot of us think that the Fed should be trying to engineer more inflation. But suppose they do that, a bit too successfully, and the inflation rate reaches 4 or 5 percent with the potential to go even higher. That would send long-term interest rates up to at least 7 percent, causing bonds to lose over half of their value. Surely, that has the potential to bankrupt a number of large financial institutions. If your model of the world is that the Fed cares more about bank solvency than about unemployment, then you can see why the Fed would try to avoid an uptick in inflation as much as possible.

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COMMENTS (3 to date)
Sean writes:

Isn't a bubble in bonds less likely since their valuation is a relatively straightforward mathematical relation between interest rates, arbitrage, and inflation? Granted there are assumptions and risks involved, but a negative interest rate is, while not impossible, at least much less sustainable and plainly visible than a negative implied return due to an insanely high valuation in stocks.

Ryan Vann writes:

I don't think that predicting a decrease in bond values is a particularly controversial divination. Bonds prices decrease with an increase in interest rates. It is difficult to see bond prices going a whole lot lower.

Moreover, committing a quasi argumentum ad populum within the first couples lines of a blog entry is pretty bad form.

Hyena writes:


Given that short term debt is trading near par and cannot be sold for less, it is actually impossible to see bond prices go much lower.

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