- Former Fed chair Alan Greenspan has repeated his 'irrational exuberance' warning
- This time his comments were in relation to bonds, not stocks
- Current chair Janet Yellen is likely to have similar concerns
- These concerns may be addressed in her speech at Jackson Hole on Friday
By Max McKegg
Twenty years ago, in prepared remarks, the then Federal Reserve Board
chairman Alan Greenspan uttered two words that were destined to become part of financial market folklore: "irrational exuberance". This was the context:
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets ... But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”
The wording looked innocent enough; an observation rather than a prediction. But in Tokyo, the only major market open at the time, the Nikkei slumped 3% and the damage flowed through into European and US markets in the hours that followed. Greenspan had a reputation as a market “guru” and his suggestion US stocks might be a bit overvalued struck a raw nerve.
The Fed boss was commenting specifically on stock prices at the time, but earlier this month the now 91-year said that it was “perfectly fair” to say that irrational exuberance was now at play in the bond markets.
Bond market bubble? Earlier this month, former Fed chair Alan Greenspan warned of
'irrational exuberance' in relation to bonds. Photo: Shutterstock
The current Fed chair Janet Yellen
doesn’t have the gravitas of her predecessor. Nevertheless, her position guarantees traders take note of everything she says. Thus the scene is set for Yellen’s speech at the Jackson Hole symposium early on Friday morning, where the focus of her address will be on financial stability.
The next meeting of the Federal Open Market Committee
is not until September 19-20 so she will not be in a position to speak of behalf of the committee as far as monetary policy is concerned. She will, however, be free to discuss issues around balance sheet reduction, a plan her colleagues have already signed off on in principle.
The reason Yellen wants to discuss issues around financial stability is likely to be that the markets have yet to adjust to the reality of the Federal Reserve withdrawing itself as an underwriter of the bond market. The Fed may be concerned that bond prices
are “unduly escalated”, based largely on “irrational exuberance” at a time when quantitative easing is about to morph into quantitative tightening.
If so, that reality could hit home all of a sudden, producing a selloff in bonds with implications for financial stability in a range of asset classes.
Adding to the risk is that bond market valuation excesses are not confined to the US. Consider this chart of the yield convergence between Eurozone junks bonds and US Treasuries.
Source: The Atlas Investor
One point Yellen is likely to raise is around the term premium, the extra return investors earn in exchange for taking the risk of owning medium-long term maturity securities. There are various ways of estimating the term premium but all of them agree it is currently negative in the US –hardly what you would expect when the Federal Reserve, the buyer who drove it down there in the first place, is about to withdraw from the market.
Source: Morgan Stanley
Furthermore, at a time when the Fed is moving to the sidelines, new issuance of US treasuries is set to increase. The situation in a global context is illustrated in the chart below.
Over the past few years, central bank buying has been more than enough to absorb new issuance but as the Fed stops buying, the Bank of Japan slows down and the European Central Bank begins to taper, new buyers are going to have to take up the slack. Higher yields, perhaps much higher, will be required to entice them.
Source: Morgan Stanley
Another related issue that Yellen is likely to raise is that of the overall financial conditions in the US. Factors such as record stock prices, low credit spreads and a sinking USD mean that financial conditions have been easing over the last year, despite Fed rate hikes, as shown in the chart below.
This will an incentive for the FOMC to regain the initiative by sticking with its current “dot plot” of projections for the federal funds rate at its September meeting. Current market pricing is well below those dots and bonds would sell off sharply if traders become convinced the Fed’s forward rates curve, not theirs, is the one likely to become the reality. Yellen will have a chance to make that point on Friday.
Source: Goldman Sachs. Create your own charts with SaxoTrader; click here to learn more
Earlier this month we had a blast from the past – former Federal Reserve Chairman Alan Greenspan repeating his “irrational exuberance” warning, this time in relation to bonds, rather than stocks. Current Chair Janet Yellen is likely to have similar concerns and these may be addressed in her speech at Jackson Hole on Friday.
– Edited by Gayle Bryant
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.