EC No, Bonds Aren’t Overvalued. They’re A Warning Sign

Okay, maybe not so clearly. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

Again, the correlation should be surprising given that lending rates get adjusted to future impacts on capital.

  • Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.
  • Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs. 

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.

Longer Views Tell The Same Story

“But Lance, this year, GDP is expected to surge to 6%, so doesn’t that change things?”

The answer is “no.“

The jump in GDP growth in 2021 has several problems attached to it.

  1. It is a recovery from deeply depressed levels in 2020, not expanding growth absorbing population growth.
  2. The recovery is a reflection of an artificial stimulus that has a minimal effective window before depletion. As such, it has an almost negative multiplier effect economically. 
  3. Lastly, given that businesses understand the “bump” of activity is temporary, they are unwilling to make long-term investment commitments requiring a cost-of-capital above longer-term economic growth projections.

As Goldman Sachs recently showed, economic growth will quickly return to 2% growth trends as the “artificial” support fades.

These “bumps” of activity are not uncommon throughout history. However, if we smooth the data using a 5-year average of both the economic composite and rates, the correlation emerges.

As shown, the current 5-year average suggests that rates and growth will continue to run along much lower levels. Such does not foster increased capital investment, strong employment above population growth rates, or increase labor-force participation rates. With a near 90% correlation, economists and analysts will likely be disappointed as growth slows and rates fail to rise. 

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William K. 1 month ago Member's comment

Interesting and profound! In addition, that statement,"While Central Bank interventions boost asset prices in the short-term, there is an inherently negative impact on economic growth in the long term." is so very correct, at least as it applies to the majority of folks. Based on the results over the past 60 or so years, if we look at real growth instead of inflated price growth, the benefit has not been there for a large portion of the population.

So it will be very educational to see what the future actually does bring.