Economy

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.

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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.

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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.

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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.

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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

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