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Potential Fed Rate Hikes Fuel Uncertainty in Stock and Bond Markets

Rosalie Bull and Katherine Ingram

In a January 31st interview with Bloomberg Markets, Alan Greenspan, former chairman of the Federal Reserve, unknowingly anticipated the sharp drop in U.S. stock markets this week. Greenspan said, “There are two bubbles: We have a stock market bubble, and we have a bond market bubble.”

From last Friday to this Monday, the Dow fell over 1,800 points, its sharpest percentage decline since the European debt crisis in late 2011 and its largest point decline in history. Why did the market drop? One large reason is monetary policy by the Federal Reserve. The Fed is expected to raise interest rates three times in the coming year. The Fed tightens monetary policy to restrain an expansionary period and smooth out economic growth. Higher interest rates discourage borrowing as loans become more expensive. Financial assets, like stocks and bonds, are inversely related to interest rates.

The current value of a stock is based on investors’ belief in its future value. Higher interest rates cut into companies’ profit margins. Anticipating higher interest rates in the future, investors believe stock prices will fall. Another reason is simply that the Dow had been steadily rising throughout 2017. In the past 5 years, the Dow has risen from an average of less than 14,000 points to a little below 25,000 points. Analysts consider the plunge a necessary “correction” to maintain stability in the stock market.

Despite widespread concern about the falling stock market, Greenspan claims that the bond market bubble is a more critical issue for the US economy in the long run. Trump’s tax plan, which includes $1.5 trillion in tax cuts to the wealthiest members of our economy, paired with profligate government initiatives, is expected to lead to a large increase in the current budget deficit. This budget gap will be funded by debt spending, meaning that the US government needs to sell more bonds. The increase in bond supply lessens their market price, raising their expected yields (bond prices and bond yields are inversely related). Yields indeed hit a four year high Thursday --coming up from historic lows-- making them more attractive to investors than stocks, which are more volatile. The Fed is expected to raise interest rates, tightening monetary policy, in response to the low prices and high yields on bonds. Though bond yields generally fall with rising interest rates, the relative strength of the bond market compared to the stock market at the present moment has increased. Greenspan claims the consequences of the anticipated bond bubble are unlikely to be realized in the short term, but in the long term may lead us toward stagflation.

Critics claim Greenspan’s concerns are unwarranted; more representative of an availability heuristic than real market analysis. Matthew Graham, COO at Mortgage News Daily, believes Greenspan is attributing too much importance to a rise in bond yields and rates because he was an active economist during the 70s and 80s when a bond market bubble and collapse wreaked havoc on the American economy. Graham claims that most economists paying close attention would recognize the increase in bond market yields as simply a recovery from the historic lows of the recent past, not the beginning of an inflationary period.



17 thoughts on “Potential Fed Rate Hikes Fuel Uncertainty in Stock and Bond Markets

  1. the prof

    The phrase "availability heuristic" is new to me. I suspect this is a version of "the sun also rose" aphorism in journalism, that it's very hard to stop at saying what happened, and not posit a reason for why it happened. If (see Krugman and Wells Ch 10 on the Efficient Market Hypothesis) the stock market is random in the short run, it's inappropriate to try to spot a cause for or read a deeper significance into short-term changes.

    Anyway, by the end of the term we'll have more observations on interest rates and stock prices and inflation and growth. And (un)employment. Remind us to look back on early February and see whether what happened in the stock market was "noise" and not something of greater significance.

  2. bernsteinl20

    Is it bad that our economy has these "necessary plunges" that seem incredibly volatile? Is there a better way to regulate the economy so that we don't have these massive bubbles that end up needing to burst. Is the American mindset just poorly trained at understanding that stock market fluctuations are natural and that if it is growing consistently for a long while its not uncommon that eventually there will be a bump in the road?

  3. bbschaeffer1

    Would the central banks of other countries cause the Fed to change its decision on hiking rates? I do not expect stagflation to occur -- unemployment remains unchanged at 4.1% and there does not seem to be any indication that it will return. However, inflation will likely rise within the next 9-12 months if the Fed does not take action and begin the process of raising interest rates.

  4. riversc20

    The sharp increase in the Dow in the past 5 years and bonds hitting a four year high just this past Thursday are two very interesting statistics. What stood out to me even more is the $1.5 trillion dollar tax cut Trump is making for the wealthiest of the US economy. However, it is beneficial for this debt spending that the strength of the bond market is augmenting. All these relationships being so intertwined and dependent on one another lead me to believe these markets can be fragile and hopefully in the long-term Greenspan's stagflation predication won't prove to be true.

  5. mannm20

    Greenspan's biases definitely could have influenced his analysis of the bond bubble in its relation to long term stagflation and economic havoc. However, I think that without the future knowledge of the Fed's actions in raising interest rates and adjusting monetary policy, we cannot determine whether the economy will face the drastic downturn Greenspan predicts in the long run.

    1. minsong20

      It feels shortsighted to dismiss Greenspan as an old economist. It seems pretty clear that, although trending upward, the economic markets are rather cyclical. Going through the worst of a bond bubble would make someone properly concerned about another, although possibly hyper vigilant.

  6. pinhof18

    What's most interesting to me is how talkative Greenspan is about his opinions on the Fed and the interest rates since he retired as chair! Curious to see if Yellen will give as much insight, now that her words do not hold as much weight as they did two weeks ago. Powell is definitely keeping his lips sealed.

  7. dugganj20

    The fact that the government uses bonds to support its debt spending causes some concern. Is this a reliable, stable source to base tax cuts off of? If Greenspan is right in that we have a "bond bubble," is there not a risk that this might not collapse just like the housing bubble of the early 2000s? I agree with Greenspan in that the bond market bubble is cause for concern in the long run, and I think both economists and the government should keep this in mind.

  8. dodsonm20

    Our country is in a very interesting predicament. I get the sense from your article that there are really only two choices for the feds, lower taxes and raise interest rates putting our economy in jeopardy of a collapse or keeping taxes high and upsetting the general public. Do you think there is a common ground that could be found that please the general population but also helps our economy and national debt?

    1. the prof

      The public will be much more upset if they lose their jobs because of a poorly functioning economy! If our Representatives and Senators care about nothing but getting reelected, then why did they bother running in the first place? Ego?

  9. samuelm20

    It i s very interesting to see the monetary policy we learned about in class applied. The Dow is an represents how 30 large companies have traded. If the large companies are affected, this can only emphasize how much more the smaller companies will be/ are affected. The sharp drop is unlike any seen in the past year, and is very concerning. As this data is released, I can only imagine it will drop more because people will panic and further the lower expectations for future trade.

  10. prochniaka20

    It's interesting that you brought up the idea of the availability heuristic. When relying on what first comes to mind, it is easy to manipulate thoughts and conclusions that may not be correct. While I have studied this concept through a psychology point of view, I found it interesting to see how it was applied to an economist.

  11. scottm20

    I like the incorporation of both sides to actualize the argument, with Greenspan's statements adequately presented and his critics rebuttals subsequently provided. It is interesting to observe the inverse relationships between stocks/bonds and interest rates, and bond prices and bond yields. Knowing the way the prices effect each other, trends can be realized and forecasted. Personally, I agree with Greenspan that there is an existing bubble over both the stock market and bond market. However, considering the rebuttals to his statements claiming heuristic misguidance from past experience, the chance of the recent market performance simply being a market correction/recovery becomes a real possibility.

  12. Pingback: The Power of US Debt – Econ 102 Macro Principles

  13. the prof

    Greenspan didn't believe there was a real estate bubble. With hindsight we know he was very wrong. But a separate issue is whether the Fed had any ability to influence "froth" in a handful of financial markets. That's a very specific issue, while the Fed's influence is only over economy-wide interest rates. You might be able to raise rates high enough to prick a bubble, but collateral damage from higher rates might be worse than letting the bubble break on its own. [I know, in this case low rates = high bond prices are the potential bubble, so raising rates does pull down bond prices.]

  14. Edward Calley

    I find the relationship between government fiscal policy and the monetary policy that the Fed implements. With Trump's new tax plan, we see that the deficit will be affected and thus bond prices. The Fed simultaneously seeks to control interest rates in order control growth and avoid any instability. The inverse relationship between bond prices and yields also plays an interesting roll in affecting the balance that the government and central banks try to maintain.

  15. skinnerf20

    Just as Trump's comments influence the economy, I wonder if Greenspan's public opinion on the stock/bond market has influenced these shifts. If he has this influence it is interesting that he would be willing to make such comments.

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