valuing bonds …and stocks
Conventional US financial markets wisdom–maybe glorified common sense–says that the yearly return on financial instruments should consist of protection against inflation plus some additional reward that varies according to the risk taken. For stocks, the belief is that they should earn the inflation rate + six percentage points for risk annually; ten-year government bonds should return inflation + three percent.
If inflation is 2%+, this means the 10-year Treasury should have an annual yield of 5%+.
Stocks should have a total return (price change + dividend received) on average of 8%+ yearly.
last Friday
the 10-year
Last Friday, the 10-year Treasury yield broke below 2%, to an intra-day low of 1.95%!
Austria
Even weirder, across the Atlantic, the Austrian government is warming up to issue 100-year bonds yielding 1.2%. Demand appears to be strong, possibly because its issue of century bonds in 2017 at a 2.1% yield is up in price by about 60% since. Of course, it’s also true that many EU sovereign instruments are trading at negative interest rates–a result of central bank efforts to stimulate economic growth there.
Trumponomics
Odder still, but probably not that surprisingly, Mr. Trump is actively browbeating the Federal Reserve to lower interest rates further, despite the fact that virtually no domestic evidence is calling for further distortion to rates. I say “virtually,” because there is one contrary–the administration’s policy on trade and immigration. If there is a master plan behind that, I guess it’s what Mr. Trump believes is needed to assure his reelection. One issue for him is that the price increases he has put on imported goods have offset almost all of the Federal income tax reduction the average American family got last year. In addition, the seemingly arbitrariness and changing nature of Trump tariffs–plus the radio silence of Congress tacitly approving of the circus–appear to have slowed domestic capital investment significantly. More forethought is likely out of the question for the administration …hence Mr. Trump’s Rube Goldberg-esque call for counterbalancing monetary stimulus.
???
I’ll happily confess that I’m not a bond expert. For what it’s worth, I don’t like bonds, either. But the present state of affairs in the bond market–the absence of any return above protection from inflation– seems to me to say that money policy in the US and EU is still enormously stimulative, no longer effective and need of careful handling in extracting us from this situation. The last thing we need is higher taxation through tariffs and even more distortion of yields.
What would make someone want to buy the proposed Austrian century bonds anyway?
…the greater fool theory, i.e., the idea I can sell it at a higher price to someone else (which certainly worked with the 2017 issue)?
…the fact that lots of EU government instruments sport negative yields, so this may be a comparatively good deal?
…I’m a bond fund manager and need coupon payments so my portfolio can pay expenses and management fees to myself?
…I’m shorting negative yield bonds against this long position?
global/demographic/government influences on yields
aging populations…
Another general principle: as people get older and as they get wealthier they become more risk averse. Put another way, in either situation people shift their investment portfolios away from stocks and toward bonds.
The traditional rule of thumb is that a person’s bond holdings should make up the same percentage of the total portfolio as his age in years. The remainder goes into stocks. For example, for a 65-year old, 65% of the portfolio should be in fixed income. (I don’t think this is a particularly good rule, but it’s simple and it is used.)
What’s important is that the aging of the populations in the US and the EU (which is older than us) is a powerful asset allocation force. In the US in 2000, for example, (according to the Investment Company Institute) investors held $276 billion in funds, of which 82% was in equity funds. At the end of last year, the total was $681 billion, of which 40% was in equities. Over that time, the amount of money in stock funds rose by 20%; bond funds went up by 10x, however; asset allocation funds, which hold both, had 6.5x their 2000 assets.
national economic policy
For as long as I’ve been around, the preferred tool of government economic management has been monetary I can be applied faster than fiscal policy …and it leaves no fingers pointing at politicians if implement is painful or executed maladroitly.
The chief characteristic of expansive monetary policy is the suppression of interest rates. The burden of adjustment falls squarely on the shoulders of savers, i.e. older citizens, and the poor, who have no ability to borrow to take advantage of the lower cost of money.
More tomorrow.
Very informative
Steve
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Thanks
Dan,
Probably the rate cuts are more political insurance than economic. Actually, in the US, unemployment is so low that (1) economic “insurance” isn’t needed and (2) a slower pace of growth is inevitable given the lack of slack.
If I were Donald Trump, I’d push Powell to lower the American yield curve to European levels. Directly, I doubt it would do much for the economy. After all, any investment project that turns on a 2% interest rate rather than a 3% interest rate is a crappy project (outside of bond-land.) And outside housing, consumers pay 18% on their credit cards, so rate cuts don’t apply. It does lower the burden of budget deficits. This matters, since we have the bizarre reality of a Republican running a trillion dollar deficit, in peacetime, at full employment. I think Trump would like to try his own version of MMT with tax cuts next year.
The other benefit of pushing US yields to Euro levels is that it (1) will reduce foreign capital inflows and thus (2) push down the exchange value of the dollar. Since capital inflows to the US have been spent on imported goods, and a lower USD will encourage import substitution and improve US export competitiveness.
Until it’s over, stick with MAGA (Microsoft, Amazon, Google, Apple)!
Hi Joel,
Thanks for your comment.
It certainly is a topsy-turvy world when European managers will stretch to get a 2% yield in the US. As an observer from the sidelines, I find it hard to decide whether the current state of affairs is: just what happens when the population in a major economic center ages, or a consequence of the odd structure of the EU or one of the temporary bouts of craziness that happen in financial markets. If it’s the first, then the US is next in line.
I find the thought of tax cuts in 2020 fascinating/frightening. I imagine it would be hard for Congress to oppose in an election year and would certainly help weaken the dollar.
Personally, I’m not an Apple fan. I haven’t really understood the appeal of the stock over the past few years. But I can’t come up with a better large-cap second A.
PS I’ve been spending a lot of time in rural PA over the past several years. I’m seeing the first real evidence of recovery from recession, in the form of new construction, this year.
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