The pullback in stocks the past two trading days is both long overdue and healthful. But after nearly a decade of easy money engineered by the Fed and other central banks, is the sell-off in the bond market simply a short-term tantrum? Or is it the start of a secular bear market in bonds, due to higher inflation, that can only end in tears?
If one thinks about interest rates as simply the price of money, one could argue that the correction in stock prices would be more worrisome if accompanied by significantly lower bond yields than higher ones. In that regard, higher rates suggest that the economy is no longer so fragile as to require the “extraordinary monetary accommodation” that has kept the federal-funds rate lower than inflation since June 2008.
With the consumer price index running at only 2.1%, higher rates appear to indicate that investors expect a stronger economy and corporate profits rather than impending inflation. The historically modest current increase in the cost of money tends to validate the rally in stock prices since President
While we all naturally tend to view our most recent experience as typical, the low interest rates some of us have enjoyed since the financial crisis have been anything but normal. They are atypical of a healthy economy that allocates capital properly. Even odder than the low level of interest rates since the “expansion” started in 2009 has been their invariability. Historically, the yield on a 10-year Treasury note has been roughly equivalent to the level of nominal growth in gross domestic product (real growth plus inflation). That would imply that the rates should have averaged 3.4% since 2009 and should be roughly 5% today. Instead they have averaged only 2.45% and are now 2.71%. Why?
The academic economists who have been setting monetary policy would see this as heresy, but there may be a sense in which the best intentions of the Federal Reserve to save the world from the financial crisis at some point started to impede economic progress rather than foster it. More troubling, there is evidence that the Fed’s policy mix of easy money and tight financial regulation disproportionately benefited wealthy people with financial assets while hurting poor and middle-class people who earn interest on their savings.
Since the financial crisis, stock and bond prices have soared while interest paid on deposit accounts has plummeted. Higher long-term interest rates suggest that investors have come to believe that the outsize influence of global central banks on economic growth is ending. That’s good news for those who believe that the collective wisdom of markets, while imperfect, is better at allocating capital than small groups of unelected officials.
Many remain skeptical that the new tax law will spur economic growth. With no reason to think the federal government will curb its profligacy, it is fair to worry about the legislation’s long-term impact on interest rates, the deficit and the dollar. In the short term, however, it’s best not to overthink it. All historical analogies are imperfect, but the 2003 tax cuts are a reasonable guide to what investors can expect in 2018. Based on that experience, long-term interest rates, earnings and nominal economic growth should all rise this year. If there is any bad news, it is that higher inflation and interest rates are likely to make it harder for earnings multiples to expand, ending the market’s ability to outperform the underlying economy as greatly as it has. The good news is that the real economy and corporate profits should boom while a rising and more variable cost of capital should prompt corporations to seek higher returns through capital investment rather than share repurchases.
While free markets can be unsettling, it is difficult to find a lot wrong with the economy today. Consumer spending, capital investment, and government expenditures are rising or likely to rise while a weaker dollar should help offset the trade deficit. These expectations for stronger economic growth are being reflected in long-term interest rates and are currently nothing to fear. Inflationary pressures are likely to build, and the Fed has started the long-awaited process of “normalizing” short-term interest rates.
With liquidity ample and corporate profits set to surge, stock prices should continue to rise. Higher interest rates will temper the urge for investors to pay for growth at any price. In the long run, that is a good thing.
is chairman of Strategas, an investment-strategy, economic and policy research firm.
Appeared in the February 6, 2018, print edition.