Since the FOMC began to taper its bond purchases at the beginning of this year, the 10-year Treasury yield has declined by 40 basis points from 3.0% to 2.6%. This has caused puzzlement in the financial commentariat:
"The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined." (WSJ, 05 May 14)
This amazing phenomenon does not come as news to readers of my blog. I have been calling attention to the tightening of monetary policy for the past two years. The fact that the Fed has given up on QE is a signal of even greater tightening, which is entirely consistent with falling bond yields. Today's bond market is looking at a very subdued horizon:
6.0% money growth, the impact of which is further diminished by declining velocity;
1.2% inflation, which is 40% below the Fed's target;
3.7% nominal growth, which is inadequate to sustain anything like 4% real growth - which was in fact zero (QtQ) in the first quarter;
A complete absence of any discussion at the FOMC of taking concrete steps to accelerate money growth.
We are also told that falling bond yields are a bearish signal for stock prices:
"One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds." (WSJ, 05 May 14)
It is true that the depressed economic outlook is bearish for the rate of corporate earnings growth, but this does not translate into a bearish outlook for equity prices. That is because, ceteris paribus, declining bond yields increase the relative premium being paid to stockholders. Damodaran at NYU calculates the equity risk premium at 5.1% as of May 1st. This compares with an all-time high of 7% during the Crash and an all-time low of 2% in 1998. The current level is considerably above the historical mean. Stocks offer a relatively attractive prospective return in a world of ultra-low interest rates.
The ERP is elevated because bond yields are very low, not because of the outlook for earnings growth. The threat to current stock multiples is not low earnings growth, but instead higher bond yields. Given the current subdued outlook for growth and inflation, I see little reason to expect higher bond yields anytime soon.
There is a widely-held view that bond prices have been artificially supported by QE, and that the end of QE should herald lower bond prices - that financial markets have been artificially supported by "massive monetary stimulus." The empirical evidence suggests that bond prices were not inflated by the Fed, and that the withdrawal of QE will not result in lower bond (or stock) prices.
My view has been that, because QE has failed to increase money growth, inflation and nominal growth, it has not raised bond prices. This is because inflation expectations have declined during QE, which should not have occurred during a period of "massive money printing." Pre-crash, 10-year inflation expectations were above 2.5%. Today, they are 2.2% - despite a quadrupling of the Fed's balance sheet. The tapering of QE is a signal that nothing more will be done to raise inflation expectations, hence the rise in bond prices. QE was nothing but a sideshow: a huge distraction from the Fed's continuing failure to get control of money growth.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long stocks and bonds.