Proving this point, in a recent post titled Shadow Banking, Bubbles and Government Debt, Karl Smith writes (my emphasis in bold):
“While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.”Smith clearly recognizes the effect of holding interest rates below growth, but assumes this is will not happen over a 30-year period. If the belief that T-bill rates (and nominal GDP growth) average more than 3.3% for the next 30 years comes true, than long-term Treasury bonds are certainly overpriced (yield is too low). Stemming from this view, Smith claims:
“US Government debt is in a bubble.I am coming to believe that bubbles are a persistent feature of the modern global economy and extend from the fact that the world is aging.”Summing up Smith’s view, our economy experiences frequent bubbles but since interest rates and nominal growth are ultimately aligned, an aging economy is the likely reason. But here’s the trouble, why should we assume interest rates and nominal growth align over time? Using Bloomberg I pulled up the following charts displaying quarterly data of the Federal Funds Effective Rate (FEDL01) and US Nominal GDP growth, year-over-year and seasonally adjusted (GDP CURY), for the past 50 years.
The top chart shows the actual levels for both data series while the bottom chart depicts the spread between nominal GDP growth and interest rates. Within the bottom chart, green areas represent periods where the interest rate was less than the nominal growth rate (r < g). What may be a surprise to many, apart from a period between 1979 and 1991, interest rates are almost always below the nominal growth rate. In fact, over the last 50 years, interest rates on average were more than 1% below the rate of nominal growth.
A simple look at empirical data clearly shows the assumption that interest rates and nominal growth align over time to be false (at least within a 50-year time frame). Combining this data and Smith’s own analysis, our “economy will persistently overheat or stagnate.” Interestingly, only looking at the past 20 years of data, interest rates were on average 1.4% below the nominal growth rate, which happened to be 4.7%. Current 30-year Treasury rates of 3.3% are therefore exactly what investors should expect, if the next 20 years actually resemble the previous 20. While one should not expect a replica of the past 20 years, one thing is certain, Treasuries are NOT in a bubble!