By Frank Shostak *
After closing at 0.53% in July 2020, the yield on the ten-year US Treasury bond rose relentlessly, closing on Tuesday, September 28, 2021 at 1.55%. It is increasingly likely that the 0.53% figure for July 2020 was the lowest point.
How should we see this in the context of historical trends in bond yields?
First, it is important to consider the behavioral foundations of buying bonds.
Generally, people give a higher valuation to present goods compared to future goods. This means that present goods are valued at a premium over future goods. This is because a lender or investor is forgoing certain benefits at the present time. Therefore, the essence of the interest phenomenon is the cost borne by a lender or investor.
An individual who has just enough resources to keep him alive is unlikely to lend or invest his meager means. The cost of lending or investing for him is likely to be very high – it could even cost him his life if he were to consider lending part of his means. Therefore, he is unlikely to lend or invest even if he is offered a very high interest rate. Once his wealth begins to increase, the cost of the loan or investment begins to decrease. Allocating a portion of one’s wealth to loans or investments will to a lesser extent undermine the life and well-being of our individual today.
We can deduce, all other things being equal, that anything that leads to an expansion of the wealth of individuals leads to a fall in the interest rate, that is to say a fall in the premium of the goods present on the future goods. Conversely, the factors that undermine the expansion of wealth lead to a higher interest rate. Observe that while the increase in the wealth pool is likely to be associated with a decrease in the interest rate, the reverse is likely to occur with a decrease in the wealth pool.
People are likely to be less eager to increase their demand for various assets, thus increasing their demand for currency compared to the previous situation. All other things being equal, this will translate into lower demand for assets, lowering their prices and increasing their returns.
Note again that increases in wealth tend to reduce individuals’ time preferences while decreases in wealth tend to increase time preferences. The link between changes in wealth and changes in time preferences is not automatic, however. Each individual decides on the distribution of his assets according to his priorities.
Changes in money supply and interest rates
An increase in the money supply, all other things being equal, means that individuals whose money supply has increased are now much richer than before the increase in the money supply. Therefore, it will likely result in a greater willingness of these people to buy various assets. This leads to lower demand for money by these individuals, which in turn increases the prices of assets and decreases their returns.
At the same time, the increase in the money supply triggers an exchange of nothing for something, which amounts to a diversion of wealth from the generators of wealth to the non-creators of wealth. The resulting weakening of the wealth building process triggers a general rise in interest rates. This implies that an increase in the rate of growth of the money supply, all other things being equal, only triggers a temporary fall in interest rates. This drop in interest rates cannot be sustained because of the damage done to the process of wealth creation.
Conversely, a fall in the growth rate of the money supply, all other things being equal, triggers a temporary increase in interest rates. Over time, the decline in the money supply encourages a strengthening of the process of building up wealth, which triggers a general fall in interest rates. We can thus see that the key to the determination of interest rates lies in the time preferences of individuals, which are manifested in the interaction of money supply and demand. Note also that in this way of thinking the central bank has nothing to do with determining the underlying interest rates. Central bank policies only skew where interest rates should be in line with time preferences, making it much harder for companies to determine what is really going on.
Assessment of historical trends in long-term returns
From 1960 to 1979, long-term US Treasury bond yields followed a visible uptrend (see chart). From 1980 until today, yields have trended downward (see chart).
From 1960 to 1979, we can also observe that the annual growth rate of the money supply (AMS) followed a visible upward trend (see graph). This caused a strong weakening of the wealth generation process due to the exchange of nothing for something. The weakening of the wealth creation process due to the upward trend in the dynamics of money supply growth has raised the time preferences of individuals, which has placed the underlying long-term returns on an uptrend.
On the other hand, the downward trend in the annual growth rate of AMS observed from 1980 to 2007 contributed to the strengthening of the process of wealth creation (see graph). This has been a major factor in the downward trend in long-term yields during this period.
From 2008 to 2011, the annual growth rate of AMS followed a visible upward trend (see graph). This has most likely undermined the wealth building process again. The upward trend in the rate of growth of the money supply enriched the first beneficiaries of the newly injected money and, as a result, their demand for various financial assets, including treasury bills, increased, thus pushing up the prices of these assets and lowering their returns. Despite large increases in the money supply, the first beneficiaries of monetary increases have benefited from an advance on the overall effect of erosion of wealth. This also prevented the upward pressure on interest rates.
The massive increases in the money supply from 2019 to February 2021 likely seriously compromised the process of wealth creation (see graph). Note that the annual growth rate of AMS was 79% in February 2021. Note also that the annual increase in dollars amounted to an all-time high of $ 4.2 trillion in February 2021. If Add to this the reckless fiscal policy of the government that amounts to a serious weakening of the wealth creation process and has likely put long-term returns on an uptrend, which may have started in July 2020.
The erosion of wealth formation has already triggered weakening economic activity and slowing the dynamics of inflationary bank lending. This type of loan is an important part of the growth rate of the money supply. The further likely decline in the wealth pool increases the likelihood of a further decline in the rate of growth of inflationary lending and the rate of growth of the money supply (see chart).
A decline in the growth rate of the money supply will weaken the increases in wealth of the first beneficiaries of the money. As a result, they are likely to reduce their demand for financial assets, putting upward pressure on rates. If the economic slump is severe in nature, this will translate into a prolonged decline in inflationary credit dynamics. Therefore, a sharp decline in the growth rate of the money supply will appear. As a result, the uptrend in long rates could be long lasting.
This uptrend is expected to take place despite the positive influence of the expected decline in the dynamics of the money supply on the process of wealth creation. Note that the likely policies of the Fed and the government to counter the emerging economic slump will delay the liquidation of various non-productive activities, thus slowing the recovery of the wealth pool.
These activities, also known as bubble activities, emerged thanks to accommodating monetary and fiscal policies. As a result, bubble activity will likely continue to undermine the wealth creation process with such policies in place. This in turn will prolong the bear market for Treasury bonds.
It is likely that the bull market for T bonds ended around July 2020. Due to past large increases in the money supply, the process of wealth creation has likely weakened considerably. This triggered the decline in the inflationary dynamics of credit and the consequent fall in the dynamics of the money supply.
As a result, this should trigger a visible rise in long-term interest rates. Attempts by the Fed and the government to counter the economic slump are likely to further weaken the wealth pool and make the economic climate much harsher.
Note that once the wealth pool begins to shrink, aggressive monetary and fiscal policies can only weaken this pool, thus weakening the core of economic growth. If accommodating monetary and fiscal policies could strengthen the wealth pool, then global poverty would have been eliminated long ago.
*About the Author: Frank shostakThe consultancy firm of, Applied Austrian School Economics, provides in-depth assessments of global financial markets and economies. Contact email.
Source: This article was published by the MISES Institute