During an interview on CNBC Thursday morning ahead of his Jerome Powell's second day of Congressional testimony, former Fed Chairman Alan Greenspan joined Ray Dalio, Bill Gross, and now Paul Tudor Jones in expecting a very unhappy ending for the decades-long bond-market rally, which in turn will remove the last remaining support under equities.
In response to a question from CNBC's Morgan Brennan about his view on markets, Greenspan said he believes we are in a bond-market bubble, and that rising long-term rates will ultimately push the US economy into a state of stagflation.
Morgan Brennan: Fed Chairman Greenspan, this is Morgan Brennan. In Light of the comments you just made and sort of this talk about budget deficits, I mean, we've heard a number of high-profile investors recently, Paul Tudor Jones, Ray Dalio, Bill Gross all say they think the bond market is a bear market. What is your take on the markets right now in light of this fiscal situation?
Greenspan: Well, you mean what do I think of markets generally?
Greenspan: Yeah, well I would say we are in a bond market bubble. And a bond market bubble really means that prices are too high and when they move down, long-term interest rates move up. And if you take a look at the structure of not price earnings ratios, but earnings price ratios in the stock market, you find that the critical issue of what engendered some of the strength in the recent period is essentially the decline in real long-term interest rates, as is factored into the market. That is in the process of changing. And I think that the bond market bubble is now beginning to unwind, and that is going to bring us ultimately into a state of stagflation. And beyond that it's very difficult to tell. This is not an easy economic outlook because there are too many variables, which we haven't seen in recent decades.
Of course, the fallout from rising inflation and yields will have far-reaching reverberations across markets, particularly the equity market, Greenspan said. That's because, as real long-term interest rates rise, equity markets will inevitably decline.
Quintanilla: I guess, do we anticipate any noticeable effects on ancillary markets, equities, for example?
Greenspan: Well, of course. If the real long-term interest rates go up and you're in the process of having - it's inevitable that the effect on stock prices is negative. In fact, that's one of the really major factors determining equity price ratios, and therefore, as real long-term interest rates rise, stock prices fall. And I'm not saying what we're looking at in the last few weeks is meaningless - meaningful, but remember, the last few weeks I think are responding to the good part of the tax cut. You know, before I got into government, I was on a lot of corporate boards in which I had to sit through preparations of capital investment expenditure processes. And what struck me all the time is when they got down to the issue, the very end of it, you had what's the pretax rate of return on this investment and what is the after-tax return. And the after-tax return is a clean cut. So when you're going down from a 35% marginal rate to 21%, that's impact on perspective investments, which is exceptionally high in a marginal sense.
So I, on the one hand, in the short-term, think the capital goods markets will be okay, but longer term productivity is in for serious diminution.
In summary, investors who're trying to discern the beginning of the next equity selloff should keep an eye on break-evens.
Greenspan: "As real interest rates rise, it's inevitable that the effect on equity prices is negative"— zerohedge (@zerohedge) March 1, 2018
So keep an eye on breakevens
Continuing on the subject of the Trump tax cuts, Greenspan said he's optimistic about economic growth in the short term, but long term, he said he's "rather dismal" due to the "gradual encroachment of entitlement spending on gross domestic savings," which is defined as GDP minus total spending. Furthermore, the tax cuts will blow out the deficit - which will only help push yields higher.