Wall Street pundits have been warning of a potential Bursting Bond Bubble for well over a year but these warnings have largely been ignored as the Federal Reserve continued to prime the pump.
Bonds have been touted as a safe investment for over 3 decades. So how can they be risky now?
Bonds are debt securities or loans. Interest rates tied to bonds move down as bond prices are bid up by investors. But unlike stocks, bond prices can’t climb higher forever. As interest rates tied to bonds get closer and closer to 0%, investors turn to other places to put their money. After all, who wants to invest for nothing in return?
Contrary to popular belief the Federal Reserve does not set interest rates on government bonds. The free market determines the price of bonds. If there are more buyers than sellers bond prices rise and interest rates fall and vice- versa. But the Federal Reserve can influence market prices by the amount of buying or selling they themselves are doing within the market.
For several years now the Federal Reserve has been buying bonds on the open market to drive interest rates down in order to jump start the economy. While the Federal Reserve has been successful in driving down interest rates the effect on the economy is subject to debate.
One thing we know for sure, the Federal Reserve cannot continue to buy $85 billion in bonds every month for eternity. When the “Fed” does stop or slow down their bond buying, prices will drop and interest rates will rise. “When” this will actually happen is anyone’s guess. But the “when” really doesn’t matter. What matters is when investors think it might happen. Within the past couple of weeks investors have become worried that the Fed buying will end sooner than later. This has caused an exodus in the bond markets driving bond prices down and interest rates up. What’s equally concerning is that the stock market has been dropping as well. In a “normal market” investors exiting the bond market move their investments to the stock market or the commodities markets. What we are seeing today is a decline in all 3 markets around the world.
What happens in the near term is anyone’s guess but the days of bonds being a “safe” investment are certainly numbered.
In the chart below you can see that interest rates have been falling steadily for the past 30+ years. But from 1949 to 1981 they were steadily rising. Within the Red circle you can clearly see the impact the Fed has had on long term interest rates.