The US bond market trades at a quite high valuation. For instance, the
10-year US Treasury bond presents a price earnings (PE) ratio of 43. In other
words: It takes 43 years for the investor to recoup the bond’s purchase price
through coupon payments; the bond market’s PE ratio even went up to 68 in
June 2012 and July 2016, respectively.
At the same time, the PE ratio of the stock market is at 23, significantly
higher than its long-term average of close to 17 for the period from 1973 to
2017. That said, the 10-year Treasury bond has become more hazardous compared
to stocks. This is exactly what the PE ratio tells us: The higher (lower) the
PE ratio, the higher (lower) the investor’s risk.
How come that US bond valuations are that high? Many economists would
argue that the reason is a “savings glut”: Relative to investments, savings
balances are high, resulting in a substantially decreased market clearing
interest rate. There is, however, another, much less sanguine explanation:
The Fed has pushed interest rates to artificially low levels. It has, in
the wake of the financial and economic crisis of 2008/2009, lowered banks’
funding costs to basically zero, and, furthermore, purchased government and
mortgage bonds on a grand scale. This, in turn, has inflated bond prices and,
accordingly, forced bond yields down.
By now, the Fed has changed course. It has raised its interest rate three
times since December 2015, bringing it to 1 percent. This, however, has not
had a significant impact on long-term yields. 10-year US Treasury yields still
trade at a low 2.4 percent. Is it possible that the Fed has lost its grip on
long-term yields? Should the “savings glut theory” be proven right in the
end?
Unlikely. Long-term interest rates are, simply put, nothing but the
average of the expected development of short-term interest rates over the
maturity of the bond. That said, even if short-term rates go up, long-term
bond yields can remain unchanged (or even decline) if, for instance, market
agents expect short-term rate increases to be short-lived (or to be reversed
soon).
The still very low long-term interest rates in the US may, therefore, tell
us something important: Investors expect the Fed to keep rates at fairly low
levels in what lays ahead; they expect the central bank to refrain from
returning yields to levels formerly considered “normal.” Against this
backdrop, the latest series of rates increases is merely seen as a cosmetic
adjustment.
Such an explanation would concur with the Austrian business cycle theory
(ABCT). It implies that if and when unbacked paper, or: fiat, money is issued
through bank credit expansion, market interest rates fall below their natural
levels — the levels that would prevail if there was no bank credit
expansion out of thin air.
This, in turn, sets an artificial economic upswing (boom) into motion.
Consumption and investment go up. New jobs are created. The economy expands.
Prices inflate. The boom, however, is built on sand. It turns into a bust as
soon as market interest rates go up, that is if and when interest rates
return to their natural levels.
To keep the boom going, the central bank must keep interest rates below
their natural levels. It cannot raise them back to “normal.” First and
foremost, higher interest rates would make the boom collapse. The credit
market would collapse, stock and housing prices would tumble, and the
financial system and the economy as a whole would go into a tailspin.
One may ask: Why is the Fed then raising rates then? Perhaps the Fed’s
decision-makers think that the US economy has overcome the latest crisis and
higher interest rates are economically justified. Others might wish to
tighten policy for getting the short-term inflation adjusted interest rate
out of negative territory.
Be it as it may, the disconcerting truth is this: Fed rate hikes will
close the gap between the natural interest rate and the actual interest rate
level. This, in turn, amounts to putting a brake on the boom, bringing it
closer to bust. It is impossible to know with exactitude at what interest
rate level the US economy would fall over the cliff.
One thing is fairly certain, though: The US economy, and with it the world
economy, is caught between a rock and a hard place. Maybe the Fed’s current
rate hiking spree will bring about the bust. Or the Fed refrains from raising
rates further and keeps the boom going a little bit longer. Ludwig von
Mises put the predicament as follows:
[T]he boom cannot continue indefinitely. There are two alternatives.
Either the banks continue the credit expansion without restriction and thus
cause constantly mounting price increases and an ever-growing orgy of
speculation, which, as in all other cases of unlimited inflation, ends in a
"crack-up boom" and in a collapse of the money and credit system.
Or the banks stop before this point is reached, voluntarily renounce further
credit expansion and thus bring about the crisis. The depression follows in
both instances.
Given current bond and stock market valuations, investors seem to be
fairly confident that the Fed will succeed in keeping the boom going, that
the central bank will not overdo it in terms of raising interest rates. And
yes, perhaps central bankers have learned a great deal in recent years,
having become true maestros in holding up the make believe world of fiat
money.
The investor should be aware of the damages caused by fiat money
— for instance, boom and bust. At the same time, he should not run for
the exit prematurely: The fiat money system might be held up for longer than
some may fear and others might hope, so that keeping inflation-resistant
assets may be more rewarding than betting on an imminent system crash.
