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March 23, 2015

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Home » Opinion » Foreign Views

Trying to predict scary scenarios for bond market

By Robert J Shiller | March 23, 2015, Monday | Print Edition

The prices of long-term government bonds have been running very high in recent years — that is, their yields have been very low.

In the United States, the 30-year Treasury bond yield reached a record low (since the Federal Reserve series began in 1972) of 2.25 percent on January 30. The yield on the United Kingdom’s 30-year government bond fell to 2.04 percent on the same day. The Japanese 20-year government bond yielded just 0.87 percent on January 20.

All of these yields have since moved slightly higher, but they remain exceptionally low. It seems puzzling — and unsustainable — that people would tie up their money for 20 or 30 years to earn little or nothing more than these central banks’ 2 percent target rate for annual inflation.

So, with the bond market appearing ripe for a dramatic correction, many are wondering whether a crash could drag down markets for other long-term assets, such as housing and equities.

I have been thinking about the bond market for a long time. In fact, the long-term bond market was the subject of my 1972 PhD dissertation and my first-ever academic publication the following year, co-authored with my academic adviser, Franco Modigliani.

Our work with data for the years 1952-1971 showed that the long-term bond market back then was pretty easy to describe. Long-term interest rates on any given date could be explained quite well as a certain weighted average of the last 18 quarters of inflation and the last 18 quarters of short-term real interest rates.

When either inflation or short-term real interest rates went up, long-term rates rose. When either fell, so did long-term rates.

We now have more than 40 years of additional data, so I took a look to see if our theory still predicts well. It turns out that our estimates then, if applied to subsequent data, predicted long-term rates extremely well for the 20 years after we published; but then, in the mid-1990s, our theory started to overpredict.

According to our model, long-term rates in the US should be even lower than they are now, because both inflation and short-term real interest rates are practically zero or negative. Even taking into account the impact of quantitative easing since 2008, long-term rates are higher than expected.

But the explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation.

Bond market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5 percent in the 12 months ending in February 1980.

Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8 percent occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5 percent in 23 separate episodes since 1900.

It is also worth noting what kind of event is needed to produce a 12.5 percent crash in the long-term bond market. The one-year drop in February 1980 came immediately after Paul Volcker took the helm of the Federal Reserve in 1979.

A 1979 Gallup Poll had shown that 62 percent of Americans regarded inflation as the “most important problem facing the nation.” Volcker took radical steps to deal with it, hiking short-term interest rates so high that he created a major recession.

Regarding the stock market and the housing market, there may well be a major downward correction someday. But it probably will have little to do with a bond-market crash.

It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.

Robert J Shiller, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University. Copyright: Project Syndicate, 2015.www.project-syndicate.org

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