What’s Driving Everything From a Market Frenzy to an Embrace of U.S. Deficits? Magical Thinking.

The Wall Street bulls who advocate very high stock prices and the politicians in Washington who advocate large deficits may be ideological opponents, but they have something important in common. Both thrive on interest rates close to zero, making stocks more valuable and debt more bearable. And both threaten to take this essentially sensible logic to the extreme.

Collect everything from large engineering supplies to

Tesla Inc.

to Bitcoin are all manifestations of what Wall Street calls “TINA” because “there is no alternative”: When bank deposits yield nothing and government bonds are almost worthless, investors grab almost anything in search of yield.

In terms of leadership, that’s not bad. The value of an asset is the future income, discounted using the interest rate, plus the “risk premium” – the extra income you expect to receive if you hold something that has a higher risk than government bonds. The lower interest rate or “risk premium” increases the present value of this future income.

This could justify a market recovery. The ratio of the S&P 500 to expected earnings has jumped from 18 in 2019 to 22 now, pushing the inverse of this ratio, the “earnings yield,” from about 5.5% to 4.6%. This closely matches the drop in the yield on 10-year Treasury bonds from 1.9% to about 1%. Low interest rates also explain the outperformance of large growth companies, such as

Apple Inc.


Amazon.com Inc,

most of which have a long way to go.

Did that go too far? Aswath Damodaran, professor of finance at New York University, blogged about the intrinsic value of the S&P 500, assuming a long-term bond yield of 2% and a risk premium on capital of 5%. As a result, the S&P was about 11% overvalued on Friday.

It may not be bubble territory, but it is certainly expensive. And while you can justify the general market level with moderately optimistic assumptions, you need even more far-fetched arguments when the focus is on individual sectors and stocks.

To justify Apple’s current value, you have to be sure of how the next few years will go. To justify Tesla, you have to be sure of how the next few decades will unfold. To justify


Well, has anyone who has bought it lately thought about it after the next few days? Well, has anyone who has bought it lately thought about it after the next few days?

The same logic of low interest rates that fuels all rallies has now permeated the budget debate in Washington. Congress borrowed about $3.4 trillion last year to combat the pandemic and its economic consequences, and President Biden has proposed borrowing another $1.9 trillion. Together, these amounts would amount to about 25 percent of gross domestic product-the largest increase in the national debt since World War II.

In promoting the package, Mr. Biden and the Secretary of the Treasury have…

Janet Yellen.

Note that interest rates are historically low. Despite this additional debt, interest costs as a percentage of GDP will not be much higher than they were a few years ago The Federal Reserve has stated that it will keep short-term interest rates close to zero for several years to reduce unemployment and increase inflation. If it succeeds, that will be good news for the bulls in the stock market and the doves on the debt.

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During the confirmation hearing, Ms. Yellen warned that the trajectory of U.S. debt is “worrying.” She said that the budget deficit must be reduced to a level that stabilizes the debt “over the long term,” meaning that the problem must be addressed another time.

As with the stock market the problem here is not Ms. Yellen’s more conventional view of interest rates and debt, but that others go further. They say that there is no limit to how much the U.S. can borrow: it can always pay off its debt by printing more dollars, and argue that more debt should lead to higher interest rates, noting that interest rates have fallen while debt has risen over the past decade. Therefore, they argue, Biden should not allow fear-mongering about debt to stifle funding for his priorities on inequality, climate, and health care, nor should he worry that some spending might not be particularly effective, such as $1400 checks for wealthy families that they would only save.

However, this logic assumes that interest rates are somehow independent of the level of debt. In fact, there is a certain level of debt that will eventually lead to higher inflation and interest rates. No one knows what that level is, although it has clearly risen as private lending has fallen. But if the United States claims that this ceiling does not exist, it probably will. “Inflation may be a bigger threat precisely because it is no longer seen as such,” said a former Fed official.

Bill Dudley

last year.

Indeed, the amount of debt that the United States can carry depends not only on interest rates but also on GDP. After all, interest rates were already low before the pandemic because GDP growth was slowing, perhaps due to the aging of the world’s population. Of course, targeted stimulus measures should now accelerate the recovery and help the economy deal with its debt burden. On the other hand, the United States has also experienced two economic disasters in 12 years that have unbalanced the GDP trajectory and led to higher debt. No matter how much fiscal leeway the United States has had, the response to these disasters has been costly: Since 2007, the federal debt has increased from 35% to more than 100% of GDP.

It may wish to keep some financial margin in reserve in case another disaster occurs.

E-mail Greg Yip at [email protected]

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