Bursting bubbles

It looks as though the US dollar bubble has finally burst. The rapid depreciation of the dollar in recent weeks has brought exchange rates closer to their long-term equilibrium level and is therefore a good thing, though of course there are both costs and benefits. My main interest for the moment is in pointing out that the bubble representations yet another refutation of the efficient markets hypothesis, this time for bond markets (which might be expected to be immune from some of the sources of inefficiency that affect stock markets, such as the influence of amateur ‘noise traders’.

As I pointed out last October,

If you accept that the $US has to depreciate at some time, then holding bonds denominated in $US, and paying interest rates lower than those obtainable in other currencies, is a dumb idea. Unless you think either that European governments are likely to default on their debt or that euroland is poised for inflation, eurobonds are a better bet, and similarly for Australian government bonds denominated in $A. But I’ve given up even the residual belief in the efficient markets hypothesis that would lead me to try and work out a coherent explanation of perverse asset prices.

The failure of the efficient markets hypothesis is not complete. As this NYT report says, the proportion of new issues of debt denominated in euros has risen sharply in the last few years (relative to the predecessor currencies, most notably the deutschmark), and is now about equal to that in dollars. Given that most debt issues involve rolling over existing debt, it’s likely that the majority of new debt is being denominated in euros, and that, as the report indicates, some holders of debt are shifting part of their portfolio into euros. But this kind of gradual adjustment is not what the efficient markets hypothesis would predict.

Update 21/5 Dean Baker at In These Times also considers bursting bubbles. He correctly traces the problems back to the Clinton boom. In addition to the stock market and the dollar, Baker is concerned about a bubble in housing prices. My instinct is to agree. But it’s worth noting that if there’s a bubble in the US, where real prices have risen 30 per cent, the situation here in Australia, where prices have nearly doubled in a lot of markets, is far more dangerous.

6 thoughts on “Bursting bubbles

  1. John
    if foreign exchange markets aren’t efficient, you should be able to back your beliefs and make money out of it.

    Did you follow your own advice and buy Eurobonds?

  2. Milton, I mentioned a while ago the remark attributed (apparently spuriously) to Keynes that the markets can stay irrational longer than you can stay solvent.

    Following this precept, I switched my main asset (my super) away from $US-denominated assets to $A-denominated, but did not attempt to engage in arbitrage, for example, by borrowing in $US to buy $A or euro bonds, since I did not know when the bubble would burst.

  3. John

    I am sure Macquarie Bank would have been more than happy to lend you the money to short the $US, and capitalise the interest if cash flow was a problem while you waited for the bubble to burst.

  4. Yes, a good thing! 70% of my 403b7’s and others have been lurking offshore since early 2000!

    By the way, what makes the bond market immune to the effects of noise traders? I mean, if LTCM’s bond “convergence” trades could go so wrong in 1998 with a near-perfect hedge, I would think the natural lesson to draw is that finite duration (even very finite duration) buys you less than you would think…

    Brad DeLong

  5. Milton, if Mac Bank is prepared to lend me money and capitalise the interest until I’m ready to repay it, I’ll be down there straight away.

    Brad, I’m not quite clear on your point about finite duration.

    As regards noise traders, you’re the expert, but I’m implicitly assuming that noise traders have mistaken perceptions, and that, in an EMH model, professionals should collect information optimally.

    If one wanted to defend the EMH in the light of the dotcom bubble one might argue that this was an exceptional event due to an influx of amateur noise traders new to the stock market (I think Malkiel says something like this). I was just pointing out that this isn’t true for the bond markets.

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