The March 2020 equity market crash has created an unprecedented situation. In an already low bond yield environment, the Federal Reserve lowered the T-bond yield even more (temporarily) and in an attempt to re-launch the economy the money stock index was increased by 26% in 2020. As result of this, the equity market recovered fairly quickly but at the same time inflation also increased as result of the increase in money stock. With higher inflation the real bond yield turned negative thus becoming an unattractive asset to invest in.
How can now the US debt be financed? Increasing the money stock even more can create a run-away effect. This is because increasing the money stock will increase inflation that will make the real bond yield even more negative (assuming the nominal value does not change) thus in any subsequent step the money stock should increase even faster together with the inflation.
If on one hand it might seem that there is no way out from the current spiral, on the other hand in this article, I’ll examine a path forward that might bring to a way out from this cycle. The analysis will look into the most appropriate increase of T-bond yield to contain the inflation between 2-4% per year and the most appropriate increase in monthly money stock to avoid an equity market pull-back as result of the increase in bond yields.
Remember: T-bond yield and the money stock index are levers. What happens to the equity market and inflation is a consequence of moving these two levers. This is not an obvious path forward. As result models have been built to analytically provide guidance on the most appropriate way forward out of this increase in inflation and equity market overvaluation.
Before digging into the analysis, let’s look at some historical data.
Figure 1 shows the money stock index variation on monthly basis between 2006 and 2021. In the chart, it can be noted that this parameter spikes during economic downturn. This is usually done as a way to sustain the economy during periods of downturn. During the 2007-2009 economic crises, the money stock reached a peak value just above 2%. Nothing compares to what happened in 2020 when it spiked to 6.5%. In this period its mean value has been calculated to be 0.49% while its median value 0.62%.
Figure 1: Money stock index variation month over month
The nominal 10Y T-bond yield is shown in Figure 2. It can be noticed that it has steadily decreased in value since 2006. Occasionally it has sharply dipped for a few months as result of temporary economic downturns. In 2020, the T-bond has experienced its lowest historical value well below 1%.
Figure 2: Nominal 10Y T-bond yield as function of time
In Figure 3 it is presented the annualized monthly inflation calculated from the consumer price index. Usually this number spikes during economic downturns. It reached a peak value of ca. 12.5% during the 2007-2009 economic crises and the 2020 COVID pandemic. Its median value has been calculated to be 2.32%. The black line in the chart represents the real 10Y T-bond yield; i.e. the nominal value compensated with the inflation. As result of the increase in inflation, this number has been in the negative territory from 2020 onward. This is somewhat unprecedented when compared with the historical data preceding 2020. Its long term median value was computed to be 0.25%.
Figure 3: Annualized monthly inflation and real 10Y T-bond yield as function of time
The US industrial production as function of time is shown in Figure 4. It can be noticed that it dips during downturns (as expected) and it has not reached new peaks after 2007. This is highlighting that the growth of the equity market is predominantly due to an increase in money supply.
Figure 4: Industrial production as function of time
To perform this analysis, it was necessary to build two models to evaluate the consumer price index (CPI) and equity market valuation (S&P500). These two models are an improved version of what it was presented in [S&P500 Mode Reference], [CPI Model Reference]. These two models now take also as input the nominal 10 year T bond yield. More specifically, the CPI was modeled as function of: money stock, velocity of money, unemployment rate, industrial output and 10Y nominal T-bond yield. The S&P500 was modeled as a function of: money stock, velocity of money, unemployment rate, industrial output, 10Y nominal T-bond yield, consumer price index and gross domestic product.
I am going with the assumption that the nominal bond yield has to increase to contain the inflation while the money stock has to increase to avoid an equity market pull back. I am also assuming that it is targeted real T-bond yield to be in the positive territory; 0.25 to 0.75%. This is an important assumption. When the real bond yield is positive then they become an interesting asset for the investors to purchase thus effectively ending the vicious cycle of the Federal Reserve steadily increasing the monthly increase percentage in money stock.
Some other relevant assumptions have been made to run the models and generate the charts presented below. More specifically, it is assumed that: unemployment, M2V and industrial output will stay at the same level at the time, the article was written. This decision was taken to focus on the most important parameters of the analysis and avoid going on the tangent. When it comes to GDP, it is assumed that its nominal value varies at the same rate of the CPI month over month variation. The just mentioned CPI is the one calculated using the model.
Figure 5 shows the nominal bond yield as function of time predicted with the simulation. The three numbers in the legend should be interpreted as follow. The first number represents the monthly increase of the money stock index. The second number represents the quarterly basis points increase of the 10Y T-bond yield. The third number represents the targeted 10Y real bond yield. In the simulation, it was assumed that when the calculated real 10Y yield reaches its targeted value then the nominal one does not increase. In the figure, it can be observed that in order to keep the inflation between 2 to 4% while reaching a positive real yield value, it can be expected for the nominal T-bond yield to increase from the current 1.52% to a value between 2.5 & 7.5%.
Figure 5: Modeled nominal 10Y Treasury yields as function of elapsed months
In Figure 6, it is shown the value of the S&P500 calculated in the simulations relative to the September 2021 market price. The numbers in the legend follow the same logic as Figure 5. The way to read this chart is the following. Currently the market seems to be 18% higher in value than its fair price. With the parameters set in the simulations in terms of money stock and nominal yield, it will take between 25 and 75 months for the fair value of the S&P500 to reach the current value.
We must keep in mind that this is a simulation that does not take into account the equity market dynamic. It is not unlikely that in the next 25 to 75 months, the market will experience a pullback followed by some uptrends as result of investors’ behaviors. The message I am trying to convey is that the current valuation is “fair” only if in the next 25 to 75 months the money stock increases between 0.5 to 0.75% per month and the Treasury yield increases between 0.25 and 0.75% points every quarter.
Figure 6: Ratio of the modeled S&P500 and the September 2021 value as function of elapsed months
In conclusion to this article. Many people might think that we are going to experience a period of stagflanation as result of the generous fiscal stimulus and very low T-bond yield. If on one hand this might be correct looking at the situation as it is now, on the other hand in this article it is shown that by carefully increasing the bond yield and simultaneously the money stock index, it is then possible to simultaneously control the inflation to 2-4% per year without creating the conditions of a major pullback of the stock market. In the article it is indicated that 28 to 80 months might be required to stabilize the situation while having the money stock monthly increase and the bond yield to ca. 2006 levels.