A bond market bubble is the biggest threat to stock prices right now, former Federal Reserve Chairman Alan Greenspan warns in a Bloomberg interview. Greenspan's comment is bound to surprise nervous equity market observers who, instead, have been focusing intently on historically high valuations, narrow market leadership, unusually low volatility and other indications of undue complacency among investors. More surprising, Greenspan tells Bloomberg that, according to the so-called Fed Model, U.S. stocks are - at least for the moment - priced at one of the most attractive levels ever in relation to bond prices. (For more, see also: The 5 Biggest Risks Facing the Markets.)

Data: Bloomberg

Unsustainable Interest Rates

"By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace," Greenspan comments to Bloomberg.

When central banks start withdrawing liquidity from the financial system in earnest by selling their bond holdings, Greenspan believes that long term interest rates will spring sharply upwards. Thus, bond prices will collapse. Greenspan says that would lead to the worst bout of stagflation since the 1970s, a period when inflation accelerated amid a stagnating U.S. economy. This environment would spark a nosedive in stock prices, Greenspan continues, because sharply higher bond yields could spur a massive movement of investor capital from equities to fixed income instruments. (For more, see also: Bill Gross: QE is "Financial Methadone.")

Bucking the Consensus

Unlike Greenspan, the consensus on Wall Street is that low interest rates will persist, at least for the near future, per Bloomberg. However, Bloomberg also cites others who share Greenspan's concerns. Binky Chadha, the chief global strategist at Deutsche Bank AG (DB), believes that real, inflation-adjusted, yields on U.S. Treasury debt is far below what actual growth levels would warrant. Tom Porcelli, chief U.S. economist at RBC Capital Markets, a division of Royal Bank of Canada (RY), indicates that inflationary pressures eventually will strike the bond market.

What The Fed Model Says

The so-called Fed Model consulted by Greenspan, as explained by Bloomberg, compares the yields on 10-year U.S. Treasury Inflation Protected Securities (TIPS) to the earnings yield on the S&P 500 Index (SPX). The current figures are 0.47% and 4.7%, respectively, per Bloomberg, which notes that the gap between the two measures is 21% greater than its 20-year average. For those who subscribe to this analytical framework, high valuations for stocks are justified for now. However, another spin on this analysis, per Bloomberg, is that investors are justified in buying the less inflated asset. If bond prices rapidly deflate, as Greenspan foresees, stock prices will soon follow.