What's Driving Everything From a Market Frenzy to an Embrace of U.S. Deficits? Magical Thinking
Traders and politicians are making new, risky arguments about low interest rates to justify their actions
The Wall Street bulls embracing sky-high stock values and the Washington pols embracing big deficits may be ideological opposites, but they have something important in common. Both draw sustenance from near-zero interest rates which make stocks more valuable and debt more supportable. And both risk taking this basically sound logic to extremes.
The rally in everything from big tech stocks to Tesla Inc. to bitcoin are all manifestations of what Wall Street calls "TINA" for "there is no alternative": when bank deposits pay nothing and government bonds next to nothing, investors will grasp at almost anything in search of a return.
Directionally, this is not wrong. The value of an asset is its future income, discounted to the present using interest rates, plus a "risk premium" -- the extra return you expect for owning something riskier than a government bond. A declining interest rate or risk premium boosts the present value of that future income.
This can certainly justify some of the market's rally. The ratio of the S&P 500 to expected earnings has jumped from 18 in 2019 to 22 now, lowering the inverse of that ratio, the "earnings yield," from about 5.5% to 4.6%.
That happens to closely track the decline in the 10-year Treasury yield from 1.9% to around 1%.
Low rates also help explain the outperformance of big growth companies like Apple Inc. and Amazon.com Inc., for whom the bulk of profits lie far in the future.
Has this gone too far? In a blog post Aswath Damodaran, a New York University finance professor, worked out the intrinsic value of the S&P 500 assuming bond yields at 2% over the long run and an equity risk premium of 5%. The result: The S&P on Friday was roughly 11% overvalued.
Maybe that's not bubble territory, but it's definitely expensive. And while you can justify the overall market level with moderately bullish assumptions, you need ever more contrived arguments as the spotlight moves to individual sectors and stocks.
To justify Apple's current value, you need a lot of confidence about how the next few years will turn out. To justify Tesla's, you need a lot of confidence about the next few decades. To justify GameStop's -- well, has anyone who bought it recently thought beyond the next few days?
The same low-rate logic fueling the everything rally has now found its way into the fiscal debate in Washington.
Congress in the last year has borrowed roughly $3.4 trillion to combat the pandemic and its economic fallout, and President Biden has proposed borrowing $1.9 trillion more. These sums would together equal roughly 25% of gross domestic product -- the largest burst of national borrowing since World War II.
In advocating for this package, Mr. Biden and Treasury Secretary Janet Yellen note that interest rates are historically low. Despite this added debt, interest expense won't be much higher as a share of GDP than a few years ago.
The Federal Reserve says it will keep short-term rates near zero for several years to get unemployment down and inflation up. If it succeeds, that's great news for stock bulls and debt doves.
In her confirmation hearing, Ms. Yellen cautioned that the U.S. debt trajectory is a "cause for concern." Budget deficits must be brought down to levels that stabilize the debt in the "longer term," she said, meaning that's a problem to address another day.
As with the stock market, the problem here isn't with Ms. Yellen's fairly conventional take on interest rates and debt, but with others who go even further.
They argue there is no limit to how much the U.S. can borrow: It can always repay the debt by printing more dollars, and dispute that more debt must lead to higher rates, noting rates have fallen as debts have risen in the last decade.
Thus, they argue, Mr. Biden must not let alarmist rhetoric about the debt hold back funding for his priorities on inequality, climate, and health care, nor worry if some spending isn't particularly effective such as $1,400 checks to affluent families who will simply save it.
Yet this logic assumes interest rates are somehow independent of the level of debt. In fact, there is some level of borrowing that would eventually push up inflation and interest rates.
No one knows what that level is, though it has clearly risen because private borrowing has been depressed. But if the U.S. proceeds as if no limit exists, it is more likely to hit it.
"Inflation might be a greater danger precisely because it's no longer perceived as such," former Federal Reserve official Bill Dudley wrote last year.
Finally, how much debt the U.S. can carry depends not just on interest rates but on GDP. Indeed rates were low even before the pandemic because GDP growth had been trending down, perhaps due to aging populations world-wide.
To be sure, well targeted stimulus now should speed up recovery, helping the economy's debt-carrying capacity.
On the other hand, the U.S. has also experienced two economic disasters within 12 years of each other, which pushed down the path of GDP and pushed up debt.
However much fiscal space the U.S. has, responding to those disasters has consumed quite a bit of it: Federal debt has risen from 35% to over 100% of GDP since 2007.
It might want to keep some fiscal space in reserve in case of another disaster.