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Financial markets signalling stagnation

Which gives us a better picture of where the economy is headed -- near record low interest rates on government bonds or a stock market that is not far below record highs? 

In Canada as well as the United States, bond yields are just above record lows. The interest rate on 10-year Government of Canada bonds is about 1.4%, meaning that investors are prepared to lock in their money for 10 years for a return well below the official 2% inflation rate target. 

If there is an upturn in the economy and short-term interest rates or inflation rise, these investors will lose a lot of money. But they will be ahead of the game if long-term stagnation and deflation turns out to be an accurate forecast of where we are headed. 

The leading explanation for ultra low bond yields is that the North American economy is likely to experience a very prolonged period of slow growth and very low inflation due to inadequate demand and surplus savings, especially corporate savings. 

As leading US economist and Nobel prizewinner Robert Shiller notes, long term bond yields are not out of line with historical experience given today's record low short-term interest rates of near zero and very low inflation expectations.

So-called financial repression in the form of bond purchases by the US Federal Reserve trying to push down long term interest rates through quantitative easing has likely also had an impact on interest rates in the United States. 

It is also increasingly recognized that zero is not the floor for interest rates, which have fallen below zero in Sweden and a few other countries. Investors will pay something for the safety and convenience of holding liquid government bonds or negative interest rate bank deposits as opposed to burying suitcases of cash in their backyards

Regardless of the reasons, the bond market is clearly telling us to expect very sluggish growth, which translates into dismal economic prospects for the unemployed and the under-employed and anyone looking forward to a wage increase.

Meanwhile, US stock indexes are near record highs, and Canadian equities have fallen relatively little from the recent high despite the collapse of resource prices. The stock markets are at very high levels compared to cyclically adjusted corporate earnings, which Professor Shiller reckons is the key real economy benchmark against which to judge if equity prices are too high or too low.

On the face of it, the bond market is telling us that the economy will perform dismally, while the stock market thinks everything is just fine.

In fact, the contradiction is not quite that stark. Given ultra low interest rates, it may make sense to invest in stocks even if the rate of growth of corporate earnings turns out to be very slow. Stocks may be over-valued by the normal fundamentals, but low dividend yields are still higher than bond yields.

Further, it may be the case that corporate profits will continue to grow faster than the economy as a whole as wages continue to stagnate or even fall. This is bad news for working families, but may be seen as good news by the stock market.

Still, it is hard not to think that the stock market is being driven in part by irrational exuberance. Many observers fear that quantitative easing is fuelling bubbles in both the stock and the bond market. Ken 

Rogoff, co author of the best seller This Time is Different, reckons that risk is being seriously under-estimated.

The key take-away for policy makers is the need to get the economy on a growth trajectory that does not require ultra low interest rates. That will require shifting to stimulus through expansionary fiscal policy, preferably through higher public investment. 

After all, there is absolutely no lack of taste on the part of investors for those low return government bonds.

Andrew Jackson is Adjunct Research Professor in the Institute of Political Economy at Carleton University, and senior policy adviser to the Broadbent Institute.

This column originally appeared in the Globe and Mail's Economy Lab.

Photo: imosaad. Used under a Creative Commons license.