The one reason why bond prices won't collapse

April 25, 2014: 5:00 AM ET

Even if interest rates rise further, bond prices aren't likely to tank because most investments are in short-term debt.

By Dean Baker

Bubble trouble?

Bubble trouble?

FORTUNE – Throughout the economic recovery, there have been a number of economists and policy types worried about a "bond bubble" – the idea that bonds are overpriced and could take a sudden tumble, giving financial markets and the economy the same sort of hits we saw from the collapse of the housing and stock bubbles.

This is seriously misguided thinking from any conceivable perspective. At the most basic level, such concerns are misplaced because there is nowhere near as much money at stake. Former U.S. Federal Reserve economist Andrew Flowers put the amount of money at stake in the bond market at $40 trillion in a recent FiveThirtyEight column. This compares to a stock market valued at around $28 trillion and the housing market at a bit over $20 trillion.

MORE: Fighting debt: How the U.S. is doing it better

While that may make the bond market seem more important, the $40 trillion number is hugely misleading. The figure refers to total debt, much of which is short-term. This is important because short-term debt doesn't lose much value when interest rates rise. If we restrict our focus to debt that stands to lose substantial value when interest rates rise – remaining duration of five years or more – the volume of debt would be well under $20 trillion.

Even here, the room for losses in this market is not nearly as large as it was in the case of either the stock or housing bubbles. The stock market lost more than half of its value from its 2000 peak to its 2002 bottom. House prices lost more than one-third of their real value from the 2006 peak to the 2011 trough.

MORE: One step backward for corporate accountability

By contrast, it is difficult to envision a scenario where the bond market loses even 10% of its value. Let's consider an extreme case: Suppose the interest rate on 30-year mortgages, which is currently around 4.15 %, rose to 5.5 %in a short period of time. This would be an extraordinary, albeit not impossible, increase. This would imply a drop in the price of a newly issued 30-year mortgage of roughly 19% -- a much smaller percentage decline than we saw with the collapse of either the stock or housing bubbles.

Furthermore, the overwhelming majority of outstanding debt has much less than 30 years until maturity. This means the potential loss in value would be far less than this 19% figure even in the wake of a sharp jump in interest rates.

In fact, we already did sort of a trial run of the impact of higher interest rates on financial markets and the economy. After outgoing U.S. Federal Chairman Ben Bernanke's famous taper talk last summer, the interest rate on 30-year mortgages rose from less than 3.5%  in the spring of 2013 to more than 4.5% in the summer. If there was any serious stress created by the associated fall in bond prices, the financial media neglected to mention it. It is unlikely that any future rise in interest rates will lead to as large a drop in prices.

MORE: What's driving the buyout comeback?

While the new interest in bubbles can be appreciated by those of us who warned of the stock and housing bubbles, it seems that those who missed these bubbles still don't have a clear understanding of what is at issue. The collapse of stock and housing posed large problems for the economy because they were the forces driving growth. The stock bubble led to an investment boom and a surge in consumption as people spent based on their ephemeral stock wealth. The housing bubble led to a boom in construction and another surge in consumption fed by bubble generated housing equity.

When these bubbles burst there was nothing to replace the huge amounts of demand they had generated. As a result, we had weak recoveries from both downturns, with the weakness of the stock bubble recession being limited in part by the demand created by the growth of the housing bubble.

While low interest rates are certainly providing a lift to the economy, it is not possible to tell a story of a comparable collapse in demand if bond prices were to tumble. In other words, there is no horrifying event that we need fear if the bond "bubble" were to burst.

MORE: For some U.S. states, budget woes are on the horizon

The bad story in this picture would be if the Fed were to raise interest rates in the hope of preventing a future collapse in bond prices. This would slow the economy and raise the unemployment rate.

The collapse of both the stock and housing bubbles was certainly bad news for the economy. The Fed should have taken steps, ideally on the regulatory side, to keep these bubbles from growing so large. However, the Fed would seriously compound its past mistakes if its takeaway is to take steps to deliberately slow growth when the economy is still below its potential level of output.

Dean Baker is co-founder of the Center for Economic and Policy Research. Follow him @DeanBaker13

  • Fighting debt: How the U.S. is doing it better

    GDP growth has been greater than average interest rates -- a big reason why America's economy has outperformed many of its industrialized neighbors.

    By Monty J. Bennett

    FORTUNE -- Throughout the U.S. recovery we've seen economic data bounce in peaked highs and lows. Real GDP growth since the financial crisis has been as high as nearly 5% year over year and as low as 0%. I expect the sluggish and volatile MORE

    Apr 24, 2014 4:59 PM ET
  • For some U.S. states, budget woes are on the horizon

    Many U.S. states are approaching the start of fiscal 2015 in better financial health than at any other point since the start of the Great Recession, but headwinds remain for some.

    By Gabe Petek

    FORTUNE -- The economist John Maynard Keynes once said, "The boom, not the slump, is the time for austerity."

    Though it's hard to imagine using the word "boom" for America's slow, often painful economic recovery, Keynes' insight has MORE

    Apr 23, 2014 1:14 PM ET
  • How to get Americans to save more at tax time

    Reminding people of the risks of unexpected financial shocks, such as unemployment and hospitalization, may not be as big of a motivator as automatically enrolling people in a savings plan.

    By Michal Grinstein-Weiss

    FORTUNE -- The worst of the recent economic crisis seems to be behind us, and although slow, the recovery is underway and Americans are feeling more optimistic about the future. For most, the lesson learned during the MORE

    Apr 15, 2014 2:26 PM ET
  • 3 reasons the economy has some spring in its step

    After a winter of confusing economic data, some important indicators show an economy coming out of hibernation.

    FORTUNE -- Blame it on the weather.

    That was a common refrain market watchers heard in recent months, as a slew of confusing data showed that consumers and the economy weren't quite as healthy as they should have been.

    First, we had a couple of lousy jobs reports -- in December, for instance, the economy added just MORE

    - Apr 14, 2014 2:24 PM ET
  • America's (quality) jobs creator: Community colleges

    To prep the next generation of workers, getting the right skills is critical. And young people don't have to travel very far to get the training they need.

    By Thomas A. Kochan

    FORTUNE -- Some Massachusetts Institute of Technology MBA students were blown away by the stories they recently heard from graduates of a local community college:

    One young graduate told how he dropped out of high school and drifted for a couple MORE

    Apr 14, 2014 5:00 AM ET
  • The proof is in the data: Time to raise the U.S. minimum wage

    The U.S. would see more consumer spending if wages rose.

    By Katie Bardaro

    FORTUNE -- The debate over raising the minimum wage has been raging on for years and only growing more heated as both the Obama administration and local governments back bills to raise the minimum wage.

    Wages have not kept pace with inflation. Real incomes for full-time, private industry workers are down more than 7% since 2006. Therefore, a typical MORE

    Apr 8, 2014 2:38 PM ET
  • 3 reasons to worry about March's jobs report

    Private sector employment levels have reached their 2008 peak, but it's still tough out there for the unemployed.

    FORTUNE -- Private sector jobs finally surpassed their previous peak in 2008, according to March's jobs report. The data bore some cheery news this morning, but it's hard to get too excited once we take a closer look.

    While the total number of jobs in the economy remains below its pre-crisis peak because of large drops MORE

    - Apr 4, 2014 10:25 AM ET
  • After 8 years, the real estate market is finally looking normal again

    Since 2006, the real estate market has either been severely depressed or white hot. In 2014, it looks to settle down.

    FORTUNE -- Real estate investors are likely suffering from financial whiplash after the wild rise and fall of home values over the last 10 years.

    The beginning of the last decade saw an unprecedented spike in real estate prices, which culminated in the bursting of the real estate bubble in 2006 and a financial crisis to boot. Then came MORE

    - Mar 31, 2014 12:50 PM ET
  • Five ways to fix the U.S. job market

    Fewer Americans are working because of flawed government policies, rather than residual effects of the Great Recession.

    By Brett House and Pierre Yared

    FORTUNE -- Many Americans still aren't working. Friday's monthly jobs report for February is better than most expected. On a deeper level, however, it underscores a lot of what we've seen in previous months: An ever-smaller share of able-bodied, working-age Americans have jobs. The 2008 financial crisis dented demand MORE

    Mar 7, 2014 8:45 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.