29 October 2019

    Interest Rates Part 1

    Is this a bond bubble?

    David McLeish

    Head of Fixed Income

    Email David
    David McLeish

    Head of Fixed Income

    Email David

    Interest rates, both home and abroad, have been setting historic lows almost weekly for the last eighteen months.  This has profound implications for us all.  It is for this reason; we are writing a series of articles that we will share with you over the next few months to address the most prominent aspects of this momentous move. We hope you find these articles informative and enjoyable to read.

    Bubble Shbubble

    Talk of a bond market bubble has crept back into mainstream media of late.  In some respects, this is a natural reaction to what has been a remarkable move in this typically stable asset class.  But what I will endeavor to explain below is that even a rather high-level assessment of the situation suggests these claims are very likely misguided.

     A bond bubble is not what you might think it is.

    Bond prices mostly have an inverse relationship to the prevailing interest rate in an economy.  So what bond bubble advocates are saying is that interest rates are somehow materially below the level that can be justified by normal fundamental supply and demand factors.

    Take a moment to let that sink in.  This is not some esoteric ‘asset’ like tulip bulbs* we’re talking about here.  They are suggesting the cost of money itself is now meaningfully wrong.

    Evidence of a bond bubble would be everywhere, as interest rates impact the value of everything.

    If the cost of money really was too low, then everyone would be falling over themselves to borrow it.  This is clearly not what is happening, even in countries that have negative interest rates!  If money really was too cheap then investment and consumption would be booming. 

    Money is also the means by which we measure the value of almost every good and service in the world.  So if there really was a bond bubble we would almost certainly also have an ‘everything bubble’.  This as people would race out and exchange their less valuable cash for other assets.  After a while of this, the price of all those other assets would be so inflated they would also be in a bubble.

    Yes, there is evidence of varying degrees of overvaluation in some assets at present.  But hardly the type of gross overvaluation that would likely accompany a mispricing of something as meaningful as interest rates.

    The more straightforward rationale for low-interest rates is that they reflect a challenging near-term outlook for the global economy.

    Therefore, should some of the current headwinds facing the global economy be alleviated, even partially, there is a good chance bond prices would fall from here.  But in the next article, I will offer up my take on why such low-interest rates aren’t having the effect they used to and why this means they are unlikely to rise back to what some perceive as ‘normal’.

    The current low-interest rate environment is far more normal than many appreciate.

    *Tulip mania was a period in the Dutch Golden Age during which contract prices for some bulbs of the recently introduced and fashionable tulip reached extraordinarily high levels and then dramatically collapsed in February 1637. It is generally considered the first recorded speculative bubble.