After the RBA Board cut the cash rate target to 2.25% last Tuesday I mentioned to a friend that the best guide to the world economy since 2008 has been Paul Krugman’s brilliant little book The Return of Depression Economics. Krugman explains how the economy can get stuck when everyone is fearful and wants to hold on to safe assets (e.g. bonds), and no one is willing to invest in anything risky. It is fear that has driven interest rates to such low levels worldwide, as investors have been willing to massively bid up the price of bonds to park their money somewhere safe and to receive the guaranteed regular coupon payments.
Much of the fear appears irrational because financial markets are effectively demanding very low compensation for inflation over the long-term. The historical experience and the dependable phenomenon of regression to the mean suggest current interest rates are abnormally low and won’t persist. Indeed, judging by the comments in its box on “The Decline in bond yields and inflation expectations” in its latest Statement on Monetary Policy, the RBA can’t find any rational reason yields are so low.
I don’t expect the fear driving abnormally low interest rates will last forever, and no doubt, before the end of the decade if not earlier, enough positive economic developments will occur for investors to realise their fears are irrational, at which time the bond market will experience a large correction, with bond prices falling and yields increasing sharply. There will be a flood of money into equities, and the sharemarket will experience large gains. Many investors have already realised this, and there is now much talk of the search for yield.
Even considering recent sharemarket gains, there appears much scope for further gains in equities. I agree with the comment by Credit Suisse analyst Hasan Tevfik reported in the Sydney Morning Herald last week (Shares in longest ever winning streak), that “If there is a bubble anywhere in the world, it’s in the bond market, it’s not in the equity market.” When the bulk of investors realise there is an unsustainable bond market bubble, money will flood out of it into the sharemarket. It’s all just a matter of time.
This isn’t investment advice, but it appears to me that the sharemarket remains an excellent investment opportunity over the medium to long-term, probably even better than the property market, but I’ll need to elaborate on that in a future post.