Fed Chair Janet Yellen apparently roiled markets earlier this week when she said that equity valuations were generally quite high, but added that they were not so high when you compare the returns on equities to the returns on bonds which are also very low.
So stock valuations are quite high, but not when compared to bond yields which are also quite low. Isn’t that just another way of saying that low interest rates have inflated stock values?
And who is responsible for “very low” bond yields? That would of course be Mrs. Yellen’s Federal Reserve. The Fed is holding short-term interest rates at zero, which caps the level of medium and long-term interest rates. Then to add insult to injury, the Fed is holding off the market over 40% of all outstanding Treasury securities with a maturity longer than 20 years decreasing the supply of available long-term treasuries.
How much higher would interest rates be and how much lower would stock valuations be if the Fed didn’t hold such a large portion of the long-bond market? Nobody can say for certain, but here is something to think about. When oil supply exceeded oil demand by a mere 2%, the price of oil plunged by 50%. Small changes in supply and demand can have a big impact on price.
Today in the bond market we have the opposite situation. The Fed has decreased the supply of long-term bonds by 40%, which one should assume has lowered the long-bond rate. Where would long-rates be if the Fed returned all those bonds to the market? Likely higher, but how high is the $64,000 question for both the equity and bond markets.