The Fed Can’t Afford to Raise Rates

      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. Thus the current decade’s risk that rising employment or “full” employment will become inflationary is not comparable to the full employment years that occurred the 1945-2000 era. Today’s “full” employment is like feeding a hungry person with unlimited celery but nothing else; it doesn’t compare to feeding someone with a well-rounded meal of different food types. In the modern era of the past 10 or 20 years here are too many employed people who have fake jobs that pay $2.50 an hour minimum wage plus tips (for waiters), or they have independent contractor or commissioned sales positions where the worker isn’t paid enough averaged over the full economic cycle.
Imagine a worker earning the national average of $55,000 a year ($26.44 an hour) loses his job and accepts a tipable waiter job that pays $2.50 an hour for 40 hours a week. He experiences a 90.5% pay cut. Yet is he is labeled as “fully employed”. He gets a W-2 because he has a “job”. A person going through that will underconsume so as to avoid financial distress and thus he will be an advocate of a disinflationary outlook which in turn affects the consumer confidence and purchasing habits of other people.
The drastically different labor market of the recent decade means that a return to the ten year Treasury Note’s real yield historical benchmark of 2.08%. is highly unlikely and incorrect. Instead the new normal means that today’s ten year yields are quite reasonable, as long as there is no QT. If QT continues to be implemented as planned it will add 0.85% to rates over seven years, but that will take 7 more years to implement. QT done at a pace of a rate increase of one-seventh of 0.85% each year that means the appropriate real rate would rise from current levels by 0.125% a year. This is insignificant compared to a probable event of a recession next year which would make rates plunge. If you owed $300,000 and your rate increased by 0.125% you would pay $31.25 more interest per month (a dollar per day), which may be tax deductible for business or for some mortgages.
However, you wonder, why not use short term rates instead of the ten year bond? Economists believe that historically short term Treasuries or Fed funds need to yield about 2% real. Currently they are about zero real, so that implies short term rates need to rise 2% from 2.25% to 4.25% nominal. If that happened while the ten year Note was stuck near the current 3.05% nominal yield then the yield curve would be steeply inverted, leading to recession, and thus making rates fall. A gap or spread of 1.25% between short term and long term yields is 41% of the yield on the ten year Note. In previous cycles when rates were higher, a 41% gap 1.25% divided by 3.05%) would be more like a gap of 2% (41% of a 5% Treasury Note), so this size of gap should be considered significant. Thus the Fed is trapped.
A rate increase of more than a token 0.25% for the rest of this cycle would come too close to creating a flat yield curve. The gap or spread between the two year and ten year Treasury is now 0.24%. The two year note is close to very short term yields, so this implies a 0.25% rate increase for Fed funds could be the highest rates can go before something breaks and recession comes.
Investors need independent financial advice about the risks of misunderstanding the correct bond yield.

2018-11-28T19:24:19+00:00November 28th, 2018|mayflowercapital blog|Comments Off on The Fed Can’t Afford to Raise Rates

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.