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.