Washington, DC, March 12, 2013 --  

America's surging stock valuations make bonds look like a bad deal. That's bad news for government finance, inflation or both.

When America's stock markets reached new all-time highs last week, it was a bittersweet moment. The market peak comes after five long years of stocks being worth less than they did in October 2007. After finally regaining that lost ground, traders were hardly cracking open the champagne. Naysayers have noted that adjusting for inflation, the market is still below both its 2007 and 2000 peaks. Further, much of the market's recent gains are artificially fueled by the Federal Reserve's extraordinary actions to keep interest rates and bond yields near zero, thereby pushing money into stocks.

While these caveats may be true, they are unlikely to alter the behavior of investors and business executives who are prone to a herd mentality. History has repeatedly taught us that investment markets are highly susceptible to psychological perceptions. During the housing boom of the 2000s, people bid up the prices of real estate because everybody else was doing the same. The same happened with stocks in the 1990s market boom. And after both markets crashed, irrational investor exuberance turned to irrational pessimism.

The return of the stock market to its numeric peak marks the end of this pessimism. The good news is that the market looks sound. The dividend yield of Dow stocks is nearing a historic high,¹ and the price to earnings ratio of stocks on the broader S&P 500 index is 13.7 today compared with nearly 15 in 2007.² That means that stocks are a better value now than they were when they last sold at this price.

But for the Federal Reserve and the U.S. Government, this milestone is fraught with peril. For years, the Federal Reserve has been dragging down the interest rate on government bonds by buying U.S. Treasuries in massive quantities. But as stock markets recover, the dynamics that make this possible are poised to change.

Consider just how crazy these dynamics have been. The return on U.S. Treasury bonds has been so low that investors actually lose money on them after inflation. Just who would buy bonds at a guaranteed loss? Other than the Federal Reserve (which buys bonds for political and policy reasons) this only makes sense for a select few people who are so risk averse that they are willing to lock in a small loss rather than accept the risk of a bigger one. But this group is tiny compared with the investment community as a whole, which is influenced as always by an irrational herd mentality.

Given the recovery of the stock market, this third group of investors is unlikely to continue buying U.S. Treasury bonds without a much higher interest rate. Now that stocks seem like a reasonable bet again, why would investors accept 2 percent return on a bond when they can get 7 percent on a stock? Clearly, more investors will now shift from bonds to stocks.

And this shift means coming drama in either the Federal Reserve's bond-buying program or the U.S. Federal Government's ability to finance its debt.

The crazy bond market has been a great deal for America's federal government. Low interest rates on bonds mean it pays only 1.5 percent of GDP to finance the debt compared to 3 percent in 1990,³ despite owing far more money. Last year, it paid $360 billion in interest payments on⁴ its 17 trillion debt. But if interest rates double in coming years (a very, very likely prediction given that the historic average is much higher) then another $360 billion will come out of the annual budget for nothing other than servicing the debt. Consider that this is triple the size of the annual "sequester" cuts that have generated so much angst this year. Imagine the angst of cutting three times as much spending, just to keep the deficit the same as the year before.

The only way to avoid this fate is for the Federal Reserve to become the primary long-term buyer of U.S. debt. Historically, fear of stoking inflation would stop the Fed from even thinking of doing this. But several years of bond-buying with only mild inflation has emboldened the Fed to believe that such behavior is acceptable.

And that's exactly the problem. The longer the Federal Reserve manages to buy bonds without sparking inflation, the more likely it will be to believe some fundamental change has eliminated the risk. Once people start to say "it's different this time," that's when you know things are about to go wrong. People said it about stock prices in 1999 and they said it about house prices in 2006. You know what happened next.

With America's stock and job markets recovering, the Federal Reserve to decide whether to stop buying bonds with printed money. If it stops, America's fiscal problems are about to get a whole lot worse. If it doesn't, then high inflation will soon be here.

Related Web Columns:

Living Like There's No Tomorrow, November 9, 2010

While the Gettin's Good
The Coming Inflationary Monster, November 17, 2009

From America to Zimbabwe, March 24, 2009

Notes:

1. CNN Money, The Other Dow Record: Dividends, March 12, 2013

2. Motly Fool, 3 Reasons Why the Stock Market of 2013 Isn't the Same as 2007, March 7, 2013

3. Yahoo Fiannce, Is the National Debt Really Too Big? February 28, 2013

4. U.S. Treasury Department, Interest Expense on the Debt Outstanding, as posted March 12, 2013