I have been sounding a warning about Alan Greenspan’s next financial war for some time now. In his own inimitable way, Mr. Greenspan has been offering up vague hints regarding his concerns over the rise in asset values. He has mentioned “froth” in some housing markets, and has puzzled over the “conundrum” of falling long-term rates in the face of his efforts to raise them.
In a speech two weeks ago, Mr. Greenspan took a sharp turn toward clarity: high asset prices pose an unacceptably high risk to the economy. Since the Federal Reserve Board is in the risk-management business, he intends for the board to take steps to eliminate that risk.
How? By attempting to drive down the value of financially based assets, including homes.
With only a single tool at his disposal - the short-term interest rate - Mr. Greenspan has been frustrated that, even as he raised that rate, the bond market responded by driving down long-term rates. Since financial assets such as stocks, bonds, rental property and mortgage-financed homes tend to rise in value as long-term rates fall, asset values have continued to spiral upwards.
I have noted for some time, and Mr. Greenspan took pains to express in his recent speech, that investors seem to have forgotten about risk. In normal times, investors recognize that some investments have more risk than others. Accordingly, investors demand additional yield in exchange for taking more risk. This additional yield is had by paying less for the investment. If an office building kicks off $10,000 a month in rental income, your yield depends on what you pay for the office building. The more you pay, the lower your yield.
As asset prices have climbed ever upwards, the income yields have fallen to levels where there is clearly no extra compensation for risk. A high-quality rental property in San Diego is today yielding less, on an after-tax basis, than a portfolio of insured municipal bonds. In other words, property owners are being paid nothing to take all the risk of owning property.
The only way that owners of these and other financial assets will make a decent return is if the value goes up. Naturally, that’s what they are counting on. But, what are the conditions that allow the property to rise in value? The next buyer in line has to accept an even lower yield.
In other words: We will only get paid for the risk of owning financial assets if we can find another fool who is willing to not get paid for risk. This spiral cannot go on forever, of course. Eventually, investors wise up and demand to be paid.
Of the many pages of Mr. Greenspan’s speech, one phrase all but leaped off the page, and I implore you to take this warning seriously: “Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.”
So, why has the bond market kept rates so low? Because it is thinking one step ahead of Mr. Greenspan. The market knows the cycle: The Fed raises short-term rates until the economy cries uncle, and then rates fall again.The bond market is merely anticipating the cycle and hoarding bonds at low yields now.
As the Fed does its work of blowing up stock and real estate prices, investors will come looking for bonds as a safe haven. Bond prices will rally, and those who got in now will profit. That’s the expectation anyway. Time will tell if it was an accurate one.
Nonetheless, Mr. Greenspan has got work to do, and he has set out to do it. I expect a continued march upwards in short-term rates until the entire economy cries uncle. The one uncertainty now is the effect of the hurricane Katrina.
Katrina’s aftermath could very well tip us into a recession, in which case the Fed can slow down its rate increases. Absent that, I will leave you with the reminder that history, like the weather, has not dealt kindly with the hubris of carefree investors.