The broad US stock index jumped March 1 by more than 2%, following a strong rally in Asia overnight. So-called “real yields” (the yield on inflation-indexed Treasury bonds) plunged, temporarily allaying investor fears that the Federal Reserve might reduce its massive purchases of US Treasury bonds. Market panic was misplaced, as we declared Feb. 18 (“Premature panic over inflation and the Fed”).
Stock valuations soared as the Fed pushed the return on safe assets like Treasury bonds into the negative. If you lend your money to the US government for five years, you expect to lose 1.8% a year after inflation (inflation-indexed five-year government bonds yield negative 1.8%). Lend your money to a corporation with the lowest investment-grade rating of Baa/BBB, and you earn the Treasury yield plus only 1.2%. After inflation, that’s still a negative return. By slashing interest rates and buying $3 trillion in bonds, the Fed pushed most investors into stocks, particularly the giant tech monopolies whose pricing power presumably will allow them a positive return after inflation.
Meanwhile, as we showed in yesterday’s Chart of the Day, the Federal Reserve is stuck with the tab for a US budget deficit of $4.2 trillion, or a fifth of GDP. Foreigners stopped buying US Treasury debt a year ago, and US financial institutions might swallow a few hundred billion worth, so the Fed has to do all the heavy lifting. That leaves Fed Chair Jerome Powell with a simple choice: He can finance the Treasury deficit at a low interest rate (by promising the market to do whatever it takes to keep rates low), or at a high interest rate, by hinting at a future “taper” of Fed bond buying.
There’s no question which Powell will choose. With US Federal debt now well above gross domestic product, every 1% increase in the cost of Treasury financing costs the Treasury another $230 billion in interest costs. If the five-year “real” Treasury yield were to return to its November 2018 level of 1.1%, the US Treasury deficit would rise by nearly $700 billion. And that would send the world’s largest bond market into a banana-republic death spiral.
The Fed will use all of its resources to keep rates down as long as it can, and that will keep investors in the stock market, despite the richest equity valuations in history. And it will do so until the orgy of money printing destroys the dollar’s role as a reserve currency. That won’t happen this year, or next. But will happen. In the meantime stock investors will continue to pick up pennies on the volcano.