When a central bank raises its basic rate to fight inflation, the 10-year becomes a safe investment and its real yield increases: it is then higher than 3%, which means that the capital gives up the stocks (the productive investment in companies) for public bonds, which is not creating richness. Conversely, in inflationary, normal or excessive period, the real 10-year yield fluctuates between 2 and 3%: the capital invested in stocks is more remunerative than public bonds, i.e. in companies which create richness, which supports the growth.
The fight against inflation is thus of primary importance. When inflation is contained within these limits, the productive investment (in stocks) is profitable, if not, the capital goes towards the public bond-holder when the monetary policy is dis-inflationary.
The optimal rate of real (deflated) growth of the GDP is 3.5%, resulting from the addition of the productivity’s gains at 2.5% and the increase in the population at 1% over the long period. With a core inflation from 1 to 1.5%, the nominal growth fluctuates then between 4.5 and 5.0%. The growth is thus quite optimal when the growth rate of the nominal GDP (4.5 to 5.0%) is higher than the 10-year nominal yield which is around 4.0%. It is what occurred in the Sixties and Seventies, with an inflationary skid not controlled in the Seventies.
Then, to fight inflation, the Fed increased its rates, which did not support the growth (the productive investment in stocks) but the bond investment of which profitability was very strong in the Eighties and Nineties.
The gains of investments in stocks must be evaluated by the reverse of the PER: for a critical PER at 20, the EPR is 5%. Theoretically, the markets stocks are in auto-regulation: if prices increase too much, yields drop. For a PER at 25, the EPR is at 4%: the investment is not profitable any more when its profitability is low.
The economic optimum is ensured around these rates of 4 and 5%. Any variation compared to the standards causes an imbalance which is propagated on the other markets.
The nominal rate of GDP growth was higher than 5% from the third quarter 2003 to the last quarter 2006, which corresponded to a strong real growth, but the situation was reversed since 2007, January 1: the nominal rate of GDP growth in the first quarter is 4.65% (year-on-year) for the a 10-year yield which is now at 5%. The current situation, with a zero growth in the second quarter compared to the precedent, is at 4% in year-on-year nominal rate. It is dis-inflationary, not favorable to the growth which decreases.
The optimal growth will be durable in the future if inflation is contained in the band from 1.0 to 1.5%. The 10-year yield will return then in the standard around 4.0%.
Inflation left in the middle of the Sixties to culminate in 1980. Two decades were necessary to restore an optimal situation, the growth is thus quite optimal when the growth rate of the nominal GDP (4.5 to 5.0%) is higher than the 10-year nominal yield which is around 4.0%,
Real 10-year yield fluctuates between 2 and 3% in the Sixties and Seventies, then it is higher than 3% during two decades,
The growth rate of the nominal GDP is higher than nominal 10-year yield in the Sixties and Seventies, and conversely thereafter,
In the Sixties and Seventies, the nominal rate of growth was higher than the 10-year yield to 3 points on average,
In the Eighties and Nineties, the nominal rate of growth was lower than the 10-year yield,
Theoretically, the markets stocks are in auto-regulation: currently, the PER is not too high because the profits are exceptionally high,
The yield of the investments in stocks must be evaluated by the reverse of the PER: the EPR. Currently, investment in stocks is still more profitable than in bonds,
***First published on June 18, 2007 on my previous blog, in French on jpchevallier.com