By Joseph Solis-Mullen *
Although the effective federal funds rate remains below 0.1%, the reaction of the markets and the financial press when the ten-year Treasury yield crossed the 1.5% threshold near the start of the month reminds us to how fragile the underlying monetary framework of our economy has become. over the past two decades. Regularly at a minimum of at least 4% in the post-war period, ten-year Treasury yields have not crossed this threshold for more than a decade and have fallen steadily since 1992.
This consistently accommodative monetary policy is forcing even the most risk-averse portfolio managers to take equity premiums previously outside their comfort zone – see JP Morgan’s 2021 Long-term capital market assumptions report. Indeed, beyond the speculation that cheap money facilitates among the most risk-tolerant asset managers, effective federal funds rates and consistently low Treasury yields cause yields to squeeze. That is, long periods of low interest on so-called “safe” US Treasuries force investors to “hit yield,” a euphemism for accepting a higher risk premium by investing in. less certain financial instruments or equities due to the lower rate of return. on safer investments. However, when the majority of market participants do so, it decreases the returns on those specific assets.
In the bond market, for example, the rush for corporate bonds is pushing up their prices and therefore lowering their yields, pushing their rate and the rate on Treasury bills closer together. Under pressure to maintain profitability and the promised returns to future clients, fund managers, whatever their risk tolerance, are all forced out of necessity in the same direction. This looming crisis is magnified when investors worry about inflation, when low-yielding securities give investors negative returns at the end of the year when measured in real dollars.
The current huge stock market bubble is largely a direct result of this phenomenon. With an average price-to-earnings ratio adjusted for cyclical variations (CAPE) on the three major indices of nearly 40, that is, companies in the three major indices trade at an average price of forty times their earnings per share, averaged over the past ten years, it’s no wonder that Fed minutes have become arguably the most important macroeconomic determinant of equity futures. As anyone who follows the particularly overweight tech sector knows, even a small, brief hike in Treasury yields or yields pushes the NASDAQ down.
The story is familiar. Looking at the last thirty years, we find that Fed policy first tinkered with, then created and then burst bubbles: keeping rates too low for too long before raising them aggressively. Far from “solving” the ups and downs of the business cycle, the so-called great moderation of the 1990s was the result of Alan Greenspan’s overactive monetary policy, triggering a torrent of cheap money and facilitating takeovers. at the slightest problem. Whether it’s a currency crisis in Mexico, a default on public debt in Russia, or even fear of the year 2000, the answer has always been the same: central bank liquidity. less expensive. What followed was the dot-com bust and recession.
Even before the so-called crisis boom, the increase since 1980 in financial crises, currency crises and bubbles, it was several government policies that kick-started the engine of financial innovation, which is wrongly blamed by many. in the press and the left. – by leaning universities towards this increased economic instability: first by destroying the existing Bretton Woods monetary system by excessive spending on social programs and war, then by capping the interest rates paid on bank deposits at a when inflation meant depositors were losing money on their deposits, while banks’ traditional source of income, thirty-year fixed-rate mortgages, simultaneously became unprofitable for the same reason. Thus, institutions, depositors, investors and borrowers have been practically plunged into the uncertain waters of increasingly complex financial innovation.
From large CDs to money market mutual funds, securitized mortgages and derivatives, financial innovation has become a staple of the U.S. economy, dropping from just 4.2 percent of GDP in 1970. at 7.4% in 2018. In the end, even the government became totally dependent. on these products to help finance its own debt and domestic consumer spending, which itself has risen from just over 60% in 1970 to almost 70% today.
It was Wall Street that acted as a magnet for foreign dollar holdings, that funded the cheap credit, reckless spending, and risky investments that have become so familiar today. Indeed, the real wonder is that the two pillars of budget and current account deficits that support the ceiling have held up as long as they have. How long they will continue to do this is a guess.
* About the Author: A graduate of Spring Arbor University, JS Mullen is currently a graduate student in the Department of Political Science at the University of Illinois. Author and blogger, his work is available at http://www.jsmwritings.com.
Source: This article was published by the MISES Institute