Yesterday’s pseudo-capitulation by the Fed chief during a speech was interpreted by the market as a sign that the Fed is very close to ending its rate increasing campaign. More experts are tilting towards the possibility of recession next year. If recession comes then yields will drop, in which case investors who own money market funds would miss out on the chance to lock in intermediate term yields. When yields drop deeply then bond issuers refinance (they “call” the bond in) and investors are then forced to reinvest at lower yields. An exception to that is that Treasuries have lifetime restrictions and Munis usually have 10 year restrictions on calling in outstanding debt. Assuming that the paradigm that recessions
I calculate the appropriate interest rate by using the ten year Treasury Note’s real yield, now 1.09%, and subtract that from a historical average benchmark of 2.08%. The difference is 0.99%, which is the amount of real increase needed to return to “normal”. However, one “little” problem: we can’t return to what used to be normal because that would require returning to a pre-GFC 2008 crash era when the EU and Japan had far less debt and no zero rate or negative rate programs. A second “little” problem is the extremely weakened ability of workers to go on strike and demand wage increases means that employment (the alleged threat to bonds) is intrinsically weak compared to several decades ago.
The Federal Reserve is boxed in. If it raises rates that will make the dollar go up too much, causing a global recession. If it raises rates that can trigger a domestic recession. If it tries cut rates to stimulate the economy that could set off another bogus stock market rally. If it tries more QE in the next recession that risks damaging the Fed’s credibility that they deviated from their goal of selling of QE-purchased assets, and it will make rates go up because of fear of inflation. If it changes things dramatically that can disrupt plans of consumers and businesses thus tilting the economy towards a lesser degree of growth. QE is actually deflationary because it destroys
Quantitative Tightening (QT) is a plan by the Fed to sell off its bond holdings to undo their acquisition of bonds during Quantitative Easing (QE) of 2009-2014. These sales or portfolio run off will be done gradually over several years and was started 13 months ago. The disposition is to be done by selling off or allowing portfolio “run off” of 15% a year of assets starting in 2020 and ending in December, 2025. The pace is scheduled to be increased next year to 15% of assets; the first year was at a smaller pace. Ben Bernanke said QE lowered rates 0.85%, other people have said it lowered rates 0.5%. Assuming we use Bernanke’s figure of 0.85% and the
Bloomberg BW ran an article July, 2018 saying B of A said aggregate QT globally from all central banks will be 4% over next 2 years (2% a year). My opinion: that’s almost nothing if someone adjusts for 2% annual inflation, or perhaps it is a 2% real shrinkage of debt over 2 years assuming a 1% global Developed country inflation rate since inflation is low in the EU and Japan. Assuming much of the debt has an intermediate term maturity or a due on sale (of the collateral real estate) clause for mortgages, then the debt will experience portfolio runoff through natural paydowns of principal by borrowers. If Fed does nothing the portfolio will naturally shrink gradually. The
Adjusting interest rates for inflation to find real yields is vital to understanding bond markets. But what about taxation adjustments? If an investor during the 1951-1965 and 1990-2008 eras of “normal” inflation rates bought a ten year Treasury bond they might typically get a 5% yield when the CPI was 2.5% and they paid 35% to federal taxes, leaving them with a 0.75% after-tax and after-inflation yield. Today they might find a 3.06% 10 year Treasury yield, less 22% tax, provides 2.39% after-tax and if they subtract CPI of 2.1% then they make about 0.29% net yield. The housing component of CPI is wrongly constructed and probably will go down when a surplus of newly constructed real estate
Today the BLS released CPI data showing the core rate was 2.1% year over year and 1.6% for the quarter. If one accepts my theory that Owner’s Equivalent rent needs to adjust the CPI downward by 0.25% (or even more), then the 90 day core CPI would be 1.35%. With oil in the mid-50’s, its dramatic drop will surely put more downward pressure of CPI in the future. I remember when oil went up above $40 in 2004 and it seemed like a big deal, a high price at the time. Adjusting for inflation, a $40 price 14 years ago is like $53 this week (it’s now $56 for WTI oil) so we are almost equivalent now to the
A popular myth is that the US deficits and recent tax cuts are so huge and out of control that the global investment community will dislike the US economy and sell off their dollar-based assets, making the dollar collapse. Assuming the recent tax cuts aren’t as effective as thought and start to reduce the cuts due to pre-set changes in the law (the whole thing reverts back in less than a decade due to Byrd amendment) then deficits may not get that much bigger. The tax law of December, 2017 actually raised taxes on corporations with offshore operations and closed loopholes such as large personal state income tax deductions, causing some personal form 1040 taxpayers to pay more. The
Yesterday’s elections imply the political situation is moving away from a pro-business tax cutting era to a more of a slow growth, centerist era. Over the next two years I expect the liberals and centerists to grow stronger, resulting in a less business friendly climate, including higher taxes. Perhaps political compromises will enable a hidden back door of tax increases. The situation is likely to lead to a lower degree of deficit supplied stimulus and thus the federal deficit may grow at a slightly slower pace. Rising taxes would act to dampen inflation and growth, making yields go down. Taxes could be increased by closing loopholes (like ending excessive depreciation deductions that only businesses would notice) or raising tariffs
Regarding the concern that interest rates will rise to dangerously high levels, I doubt this will occur. The fear that Quantitative Tightening, where the Fed sells its holdings of bonds to undo QE, will make rates go up a lot is incorrect. When QE was implemented from 2009-2014 it didn’t create inflation and probably only lowered interest rates by 0.5%. The reason yields went down was because of global fears of falling into a debt/deflation trap and because other Developed countries (the EU, Japan, Scandinavia, Switzerland) had negative rates. I don’t see things getting better in Europe; probably the economic problems have not been truly solved in Japan. Thus since the fundamental reason for low yields in the U.S.