The crucial role of interest rates

By now it’s well understood that much of the high economic growth over the past few decades was due to consumers in the West and Japan borrowing increasingly and saving less and less. Rising asset prices were the predominant collateral for most consumer credit and mortgages. But what was the main driving force behind the rising asset prices? 

We all now know that much of the high economic growth over the past few decades was due to consumers in the West and Japan borrowing increasingly and saving less and less. This often happened directly, but it also often happened in the form of extremely low pension contributions. This was all against a background of rising stock and property prices and declining rates for risky bonds (this also allowed the pension funds to manage with low pension contributions). Far too little attention is being paid to the reason why all these investments have appreciated so far in value in the past few decades. So far, in fact, that many people found investing more lucrative than working (a theoretical impossibility in the long run). It is often said that their value rose so far because the economy was doing well. This is not true, however; the economy was only doing so well because of increasing borrowing and decreasing saving. And that was only possible due to rising asset prices.

So where did the rise in asset prices come from? A study the Fed conducted many years ago into fair value for stock prices is highly interesting from this point of view. This showed that you had to take the multiple of the yield on 10-year Treasuries (one divided by the yield times a hundred) and multiply it by the earnings per share. In other words, if the yield on 10-year Treasuries is 10%, you have to multiply the earnings per share by ten; if the yield is 11% by nine and if it is 8% by twelve and a half.  The striking thing about this formula, however, is that when the yield falls from 10% to 9%, the multiplication factor for the earnings per share rises from ten to eleven, but when the yield falls from 5% to 4%, the multiplication factor rises from twenty to twenty-five. In other words, the lower the yield the more a further one-percent fall pushes up fair value. When yields fall from 4% to 3%, the multiplication factor even rises from twenty-five to thirty-three. Incidentally, a similar kind of formula applies to property, although you have to take the buyer’s income or rental income instead of the earnings per share.

Yields on 10-year Treasuries in the US and Europe have now actually fallen from around 13% in 1980 to around 3%. This is the primary reason for the accelerating rise in asset prices over the past few decades. Especially when you realise that borrowing more and more against rising asset prices caused an accelerated increase in economic growth and therefore earnings per share and incomes. Fair value therefore rose not only because of an accelerating increase in the multiplication factor, but also due to the sharp increase in earnings per share or incomes.