The third bubble

Once there were three bubbles. The one that attracted everyone’s attention was the dotcom bubble, of which no more needs to be said. The second bubble, noted by plenty of economists was the glaring overvaluation of the bubble. Given chronic deficits in both the budget and current account, and the fact that the US dollar was trading at a value well above purchasing power parity, anyone who gave any credence to the view that markets eventually reach equilibrium could conclude that the US dollar was bound to fall, and it has duly done so. (this only leaves the question of why putatively rational investors did not sell earlier)

The third bubble seemed, until this year, like part of the second. Rates of interest on 10-year US government bonds are amazingly low, currently around 4.25 per cent (the price is inversely proportional to the interest rate, so low interest rates mean a bubble in bond prices). Most economists would, I think have assumed that, as the US dollar declined in value, long-term interest rates would go up. But, apart from a brief panic a few months ago, this hasn’t happened.

Why have long-term interest rates stayed so low? There are a bunch of factors that might be considered. First, as long as it maintains ‘credibility’, the US Federal Reserve can control short-term rates. The general assumption is that this control doesn’t extend to long-term rates, but the long run is just a sequence of short runs. If the Fed keeps the short rate at 1 per cent for years on end, the long rate must also be low (otherwise you could make as much money as you liked by borrowing short and lending long). I’m not convinced by this because, carried on indefinitely, such a policy would lead to resurgent inflation. So, to maintain credibility, it can only be maintained for a few years at most.

The second part of the story is that, while individuals are getting rid of US government bonds, central banks (mainly in Asia) are buying them. You can see this in the data supplied by the Bureau of Economic Analysis.

The third, and most interesting fact is that, even as it runs deficits, the US government is, in effect, buying its own debt. More precisely, it is not rolling over long-term debt as it expires but is, instead, issuing short-term debt. For example, even though rates on 30-year bonds look like an amazing bargain for a borrower, they are no longer being issued. Similarly, new issues of 10-year debt seem to be declining.

What all this means is that things are going to get very messy in a few years time, when the need to roll over increasing amounts of short term debt coincides with the payment of Social Security to the first of the baby boomers (in this purely actuarial context, generational terms like this are of some US).

As we have seen, no matter how solid they may seem, bubbles eventually burst, and the bond bubble will be no different.

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