Bond bubble – The problem with virtual money - August 23, 2015

Bond bubble – The problem with virtual money

The financial crisis of 2008 might repeat itself, only now, the burst of the bond bubble will be the beginning of a breakdown. This is what Alan Greenspan, the legendary former Fed Chairman stated in an interview.

Even though the labour market and consumption is growing, the productivity growth is “extraordinarily low”, said Alan Greenspan, former head of the U.S. central bank (Federal Reserve) in a CNBS interview. In addition, a pending bond bubble creates an extremely dangerous situation in the American economy.

The bubble might leave a huge mess

He also talked about interest rates that are at a record low level but bonds have good return, this is why they are popular. Due to its popularity their price is high, still, many have invested their money in bonds recently.

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Source: Finviz.com
Greenspan is concerned that the second Fed raises interest rates (most of the analysts expect it for September) everyone will want to get rid of their bonds. And this is when the market will have to face a liquidity trap, that will mean a smaller demand for bonds, resulting an extreme price fall to which we have seen many precedents in the last 6 months or year.

“We have never been in a position such as this, so it is very difficult to be definitive as to what might happen or might not happen”, said Greenspan, who thinks, all in all, it is dangerous.

All depends on whether the investors can stay calm when the Fed raises interest rates. “Liquidity fundamentally is a psychological issue. We have periods of tremendous amount of liquidity in the past, which disappeared virtually overnight”, added the former Fed Chairman.

Virtual money

In this interview he also mentioned the moment when the credit crises of 2008 burst out and when it turned out what liquidity really meant. One news item about a bank went bankrupt was enough for masses to try getting their virtual money back at once.

This sudden panic proved that it is impossible to give everyone the amount of their virtual money at the same time.

From this moment on, a deflationary spiral has started, and those who had been calm until then, started to worry, they wanted to turn their stocks into money and withdraw their savings.

“Liquidity is important […] on our balance sheets. […] that's not the real test of where the real issues lie”, said Greenspan.

According to the former Fed Chairman, macroeconomic indices don’t look that good either, that we could all stay calm and not worry about the U.S. economy. Greenspan is concerned about the national expenditure. He thinks the government spend too much. Social expenditures (this goes to health care for example) in the U.S. were 19.2 percent of gross domestic product last year, up from 15.5 percent in 2005. Still, it is worth to mention that the portion of GDP spent by the U.S. last year was below the OECD average of 21.6 percent.

In April Innovative Securities wrote about the possibility of a bond bubble. The article “On the Way to a Bond Market Bubble” can be read at Yahoo Finance.