Category Archives: Interest rates

From Main Street to Wall Street

My book – From Main Street to Wall Street (link) – has been published. This blog post explains why I wrote the book and its contents. The next three posts (that will be sent out in due course) will present some of the analyses and conclusions from the book.

Background

Let me start in 2008. The financial crisis was at its worst.

I was a young professor of finance. I studied financial crises (my Ph.D. is on currency crises) and the relation between the macroeconomy and expected stock returns.

One day, I was invited to a TV program. I was asked to explain something in relation to the crisis. I do not remember the exact topic, but the appearance revealed that I have an ability to explain complicated financial issues in simple terms. There was a need for people with such skills, as many found it difficult to understand what was going on during the financial crisis. I decided that it was part of my duty as a professor at a publicly funded university to help people understand the complicated interactions between the financial sector and the real economy that were brought to surface during the financial crisis. Back then, I became something like an “academic TV star” in Denmark.

A couple of years after the crisis, in 2012, the then Danish government established a commission. Its task was to evaluate the causes and consequences of the financial crisis in Denmark. Due to my presence in the Danish debate and my research on this area, I was asked to be its chairman. I accepted the offer.

The next couple of years, I worked day and night. The report – today called the “Rangvid-report” (link) – was published in autumn 2013.

The decision to write a book

At some point in 2015, or was it 2016, i.e. a couple of years after the report, I started talking to myself about my next big project. With “project financial crisis” completed, I felt I somehow needed a new project. I decided to write a book.

I did not want to stress myself. I have been writing when time has allowed it. Sometimes, I have been able to write a lot. At other times, several months have passed when I was not able to write anything. This has been fine. No stress. In fact, an enjoyable process.

What should its topic be? The obvious topic would have been the financial crisis, given my involvement here. But, as mentioned, I had just completed writing the report of the financial crisis, and everybody else were writing books on the financial crisis. It should be something different.

I am and always have been fascinated by financial economics. Economic growth determines so many things in life. Financial markets help people fulfill some of their big dreams: buy a house, save for retirement. I have done research on the relation between the macroeconomy and financial markets. I decided the book should deal with this.

I am an empirical economist. I have done formal theory when I was young, but I have to come to realize that I do not have a comparative advantage here. Hence, I wanted the book to be a fact-based book on the relation between the economy and financial markets.

I started investigating the market. I was surprised.

Every day, newspapers and business magazines cover the latest macroeconomic news, not least to help investors navigate financial markets. Is falling unemployment good for stocks because it indicates the economy is doing well? Or, is it bad because the central bank will then start tightening monetary policy, potentially hurting stocks? Will countries expected to grow fast provide higher returns? How will economic developments affect financial markets?

Given the attention academics and investors devote to understanding the economy and its impact on financial markets, it was somewhat surprising to me that no well-known book focusing on the relation between the economy and the stock market, and targeted towards a broader audience, existed. I decided that my book should aim at filling this gap.

Of course, there are related books. The one closest to mine is probably “The long good buy” by Peter Oppenheimer (link). I like to think that my book is more thorough and has a firmer anchoring in the academic theories, given my background as an academic and Oppenheimer’s as a practitioner. Also, my book has this structure with the long and the shorter run. Lastly, and probably most importantly, I carefully explain how we can use the insights from the theories and historical evidence to formulate predictions about the future. This being said, Oppenheimer’s book is a great extra reading if you are interested in these topics.

Other related books could be “Stocks for the Long Run” by Jeremy Siegel (link), “Expected Returns: An Investor’s Guide to Harvesting Market Rewards” by Antti Ilmanen (link), and “Financial Markets and the Real Economy”, edited by John Cochrane (link). These are all great books, but they cover different aspects of the topic. Siegel’s book is a description of the stock market on the long run, whereas my book relates the stock markets to the underlying economy, over the short and the long run. “Expected Returns” focuses on providing a comprehensive overview of theories of expected returns on different asset classes, whereas my book focuses on the relation between the macroeconomic and equity markets, over the long run and the business cycle. “Financial Markets and the Real Economy” is a collection of academic articles written by many different authors, i.e. it serves a very different purpose and targets a very different audience than my book, even when the title indicates the same topic.

Writing style

The book is written in a style similar to this blog. Of course, this is a blog, so my language here is sometimes less formal than what I use in the book, but the use of tables and figures to provide a fact-based background to the relation between financial markets and the economy is similar to this blog.

I decided that my book should be academic in nature, but written in a style that is accessible to a broader audience. For instance, the book does not contain formulas or equations, except like “Real equity returns = Nominal equity returns – inflation, “Equity returns = dividend yield + capital gains”, and the like. The book presents the academic theories relating to the different topics, but in a way that should be understandable for interested non-academic readers and students.

An important characteristic of the book is its reliance on the data. Figures and tables richly illustrate and back up arguments and theories. The book is empirical in nature.

I wanted the book to be reasonably comprehensive. Its purpose is to give the reader a thorough understanding of how economic activity affects equity returns. Also, in some chapters, equity returns are compared to interest rates and bond returns.

All chapters end with a checkpoint list that summarizes key insights.

Table of Contents

A guiding principle in the book is that movements in economic activity contain a long-run and a business-cycle component. Over the long run, economies grow. Over shorter horizons – over the business cycle – economic activity fluctuates. My book examines both the long-run relation between economic growth and stock returns as well as the business-cycle relation.

After a first part that introduces fundamental stylized facts and important concepts, the remaining parts of the book are structured around the long-run and short-run relations. In my book, the long run refers to multiple years or decades. The short run to months or a few years.

Over the long run, economies grow. The rate at which an economy grows over the long run is the determinant of whether a country is rich or poor. Expectations to developments in economic activity over the long run help us formulating expectations to returns from financial assets over the long run. When a 25-year old individual asks how much he/she should save to live a decent life after retirement, i.e. after many years, the answer will not least depend on what we expect financial assets to return over the next many years. And, the answer to that question in turn depends on how fast we expect economy activity to grow over the long run. The second part of this book explains what we know about long-run economic growth, about returns on stocks over the long run, and about the relation between long-run economic growth and stock returns.

Over the short run, economic activity fluctuates. Sometimes even substantially so. There are years when the economy is booming, unemployment is low, and times are good. At other times, in recessions, economic activity falls, people are laid off, and times are rough. The recurrent alternations between good times and rough times is the business cycle. Economic activity and the stock market share a common business-cycle pattern. The level of economic activity and the value of stocks rise and fall jointly throughout the business cycle. In order to understand why stock returns are sometimes high and why they are sometimes low, it helps to understand business-cycle fluctuations in economic activity. The third part of the book explains how economic activity and stock returns stocks are related over the business cycle. This part also describes monetary policy, as monetary policy plays an important role in understanding business-cycle fluctuations and stock markets. This part of the book also devotes one chapter to the financial crisis of 2008-2009, as an example of an economic and financial event that dramatically influenced economic activity and equity markets.

When we understand how economic activity relates to financial assets, over the long run and business cycles, we are better equipped to formulate expectations to future returns on financial assets, over the short run and over the long run. This is what the fourth part of the book deals with. It explains how economists judge the outlook for the economy, and it takes us through short-run and long-run stock-return predictability. I emphasize that there is considerable uncertainty surrounding return forecasts, but also that stock returns contain a small degree of predictability. Even if it seems small at first glance, it accumulates and has important implications for academics and practitioners alike.

A final, short, section contains my view on a few practical investment advices.

Publication process

Oxford University Press is the publisher of the book. OUP has done a great job setting up the book. It looks good. The cover is also cool. I am happy.

I handed in the manuscript in spring last year, right before corona arrived. This means that I did not manage to include a chapter on the corona-crisis. If there ever will be a second edition, it will include such a chapter. Until then, many posts on this blog describe different aspects of how the corona-crisis has affected the economy and stock markets.

I received the book in print a couple of weeks ago. It is a nice feeling having published a book.

Conclusion

This post has provided some background on why I wrote From Main Street to Wall Street and its contents. My next three posts will describe some of its key conclusions. The first post will be on the long-run relation between the economy and the stock market, the next on the business-cycle relation, and the final on how we can use those relations to say something about expected future returns.

Yields and inflation expectations

During the last couple of weeks, yields have been rising and stock markets falling. Standard market turbulence is not interesting for this blog – stocks go up and down, most of the time up, and yields fluctuate – but intriguing (and expected) patterns characterize recent events.

Everybody seems to agree what is going on markets these weeks: Vaccines are successful and being rolled out, so economies will open up soon, and Biden will get his stimulus package to the tune of USD1.9tn. These two things (an already strong economy when opening up and on top of that a large stimulus package) will lead to very strong growth during the second half of 2021. Inflation will rise and the Fed will have to tighten monetary policy. The expected rise in inflation and the policy rate leads to increases in yields today. This hurts stocks. These US developments spill over to other countries.

This story largely makes sense. Looking at the data, however, interesting outstanding issues remain.

The story

Inflation expectations have been on the rise since the start of the rally in April 2020. Figure 1 shows developments in expected average annual inflation in the US over the next five years and the yield on five-year Treasuries since April 1, 2020:

Figure 1. Yield on 5-year Treasuries and 5-year breakeven inflation rate. Daily data since April, 2020. Two percent inflation target indicated by dotted line.
Source: Fed St. Louis Database

From a low level, expected inflation rose strongly during the summer-2020 rebound in economic activity, i.e. from April until August, and then stabilized. Since the election of Biden in November, inflation expectations have been on the rise again, because of the expected arrival of vaccines and the stimulus package.

Today, early March 2021, financial markets expect US inflation to be 2.4% per year on average over the next five years. Early November, expected inflation was 1.6%. An increase of almost one percentage point over the course of four months.

An expected rate of inflation of 2.4% is above the Fed’s target rate of inflation of 2% (link). With its new policy, the Fed might allow inflation to exceed 2% for some time, following a period of low inflation, such that average inflation over time approaches 2% (link). But how much more than 2% inflation will the Fed allow before it reacts? At 2.4%, markets start speculating that the Fed will raise rates to keep inflation expectations anchored.

Yields on 5-year Treasuries (also shown in Figure 1) had not moved until a few weeks ago. This also makes sense. As long as inflation is below the Fed’s two percent inflation target and the economy is suffering from the corona-recession, nobody expects the Fed to raise rates. As inflation started exceeding the target, expectations of a Fed hike started to be priced in.

Yields on one- and two-year Treasuries have not started rising yet, whereas yields on Treasuries with a maturity exceeding five years (five-year, seven-year, ten-year, twenty-year, etc.) have increased markedly during recent weeks. This means that the Fed is expected to start raising the policy rate in a couple of years only.

The rise in yields has caused turbulence on stock markets. Volatility (standard deviation of daily changes in the Nasdaq index, for instance) was 1.1% during November and December 2020 but 1.4% during January and February 2021. The same goes for the SP500 (0.83% during the last two months of 2020 vs. 1.04% during the first two months of this year). Stocks suffer.

Complications

All this (yields rise when expected inflation exceeds the target of two percent) seems fine and makes sense. The complicating feature, however, is that ten-year yields (and twenty-year and thirty-year, i.e. yields on long-maturity securities) have been constantly rising in relation to shorter-term yields since markets calmed down in April 2020:

Figure 2. Yield on 10-year Treasuries minus yield on 5-Treasuries. Daily data since April, 2020.
Source: Fed St. Louis Database

In April 2020, 10-year yields were 25 basis points above 5-year yields. Today, they are 80 basis points above.

It is thus not a new thing that yields rise. Longer-term yields have been doing so for some time. The new thing is that other yields start to rise, and that the increase in longer-term yields has accelerated during recent weeks.

We have just argued that it makes sense that markets start speculating that the Fed will raise rates when inflation exceeds two percent, and yields consequently react. But expected inflation over the next ten (and five) years has been below 2% ever since the start of the corona crisis and up until the turn of the year. Nevertheless, yields on ten-year (and longer) securities have been rising since April.

It is instructive to split expected inflation over the next ten years into expected inflation over the next five years and the subsequent five years, i.e. years 1-5 and 6-10 (the latter is sometimes called “5-year, 5-year expected inflation” or “5y5y expected inflation”):

Figure 3. 5-year breakeven inflation rate, 10-year breakeven inflation rate, and 5-year,5-year forward inflation expectation. Daily data since April, 2020. Two percent inflation target indicated by dotted line.
Source: Fed St. Louis Database

Up until January 2021, expected inflation was generally below the 2% target rate of inflation. Shorter-term (1-5 years) expected inflation was lower than long-term expected inflation (6-10 years) but also rose faster. Still, ten-year yields rose while shorter-term yields did not.

Expected inflation over the next ten years is the average of the 5 year and 5y5y expected inflation.

The complication, thus, is that while it is fine and makes perfect sense that market reacts when expected inflation exceeds 2%, it is somewhat puzzling that some yields (longer-term) react when inflation is below 2% while other do not (shorter-term), even when shorter-term inflation expectations rise faster that longer-term expectations?

(Of course, other things, such as the real rate and risk premiums, determined yields, and I briefly discuss these below, but given that there is so much focus on inflation expectations these days, we need to complete that story first).

This issue is a little bit that either you say:

“Given that expected inflation was below 2% until December 2020, it makes sense that shorter-term yields were flat until the start of this year. When expected inflation over the next 5 years started exceeding 2%, 5-year yields started increasing and longer-term yields accelerated”.

Or you say:

“I believe ten-year yields have increased since April because inflation expectations have been increasing, recognizing that expected inflation was below 2%”.

You might be able to come up with a story explaining developments before January, i.e. long-term yields rising but not short-term, and expected inflation below 2%, but it is not straightforward. One story could be that people expected the Fed to keep rates low over the next couple of years, but raise them later. This story would not be based on expected inflation, though, as expected inflation was below 2%, both on the short and the long run.

Before corona

By the way, before we continue, there actually was some relation between expected inflation and yields before the corona crisis, as there generally is. Between autumn 2018 and the corona crisis, expected inflation was falling by close to half a percentage point:

Figure 4. 5-year breakeven inflation rate and 5-year,5-year forward inflation expectation. Daily data since January, 2018. Two percent inflation target indicated by dotted line.
Source: Fed St. Louis Database

And yields were falling, too, during the same period:

Figure 5. Yield on 10-year Treasuries and yield on 5-year Treasuries. Daily data since January, 2018.
Source: Fed St. Louis Database

Real yields

Have real ten-year yields been rising between April 2020 and January 2021, explaining the rise in nominal yields? No. The fact that inflation expectations have been rising faster than nominal yields means that real yields have been falling since April 2020. And, the fact that shorter-term inflation expectations have been rising even faster than longer-term inflation expectations means that short-run real yields have been falling faster than long-run real yields:

Figure 6. Yield on 5-year and 10-year Treasury inflation-indexed security. Daily data since January, 2018.
Source: Fed St. Louis Database

Where should we look?

Given that the relation between expected inflation and yields is tricky (appears to be there now, but was muddy before January), it seems we need to think in terms of risk premiums. This is difficult. Perhaps the inflation risk premium has risen. Perhaps investors before January were more uncertain about inflation after five years than about inflation over the next five years, and demanded a compensation for this. It does not seem the most plausible story, but it is of course a possibility.

The obvious thing to shout is probably “debt”. It seems too early to go down that route, though. I present no analysis here leading credence to this story. And, there are many other potential explanations. It might be debt. But it might also be demographics, productivity, uncertainties, etc. There are many possibilities. The one that faces a hard time is trying to explain all developments in yields since the start of this rally by rising inflation expectations.

Last piece of evidence

The fact that ten-year yields have been rising faster than short-term yields during this recession is not unusual. Historically, around recessions, ten-year yields rise more than short-term yields, either during or right after the end of recessions (sometimes even right before recessions). This is what we have been seeing since April. The slope of the yield curve becomes steeper around recessions:

Figure 7. Yield on 10-year Treasuries minus yield on 5-Treasuries. Monthly data since 1983. Recessions indicated by shading.
Source: Fed St. Louis Database

The point I have been trying to make here is that the increase in the slope of the term structure (long-term yields rising faster than short-term yields) might not be unusual, but it is difficult to explain developments since April by simply saying “inflation is coming”. Expected inflation helps you explain some things, but not all.

Conclusion

Yields are currently going up because inflation expectations have started exceeding the 2% target rate of inflation. People start expecting the Fed to react at some point. This is fine and make sense. But inflation expectations have been going up for longer, since April 2020, and so have long-term yields, even when inflation expectations remained below two percent. Why did some yields (long-term) rise while others did not (short-term) when inflation was expected to remain below two percent and short-term inflation expectations rose faster than long-term expectations?