Interest Rates Continue to Edge Higher.
Interest rates peaked in early 1980 at 20% on the Federal Funds Rate, the key short-term borrowing rate set by the Federal Reserve. Known as the Prime Rate years ago, it reflects very short maturities. Longer term rates, such as Five, Ten, or Thirty Year Maturities are set in the marketplace, although the influence of the Federal Reserve is still keenly felt since they are often large buyers or sellers of longer Term Bonds. Since 1980, rates have been generally falling for an unprecedented 38 years, with the Funds rate hitting a low of 0.25% from 2009 to 2016.
As rates fall, two things happen to the markets: 1) Stocks become relatively MORE attractive as dividend yields become more competitive to Bond Yields. This pushes up Stock Prices along with Bond Prices which INCREASE as Yields DECREASE and 2) The earnings stream anticipated for a given Company becomes more valuable. Interest rates are the discounting mechanism for the future prospects of a firm. At a lower discount rate, an earnings stream is worth more. Think of it this way: A fixed rate mortgage becomes more VALUABLE and COSTLY as rates go down. That’s why homeowners refinance when rates go down below their coupon yield.
The capital marketplace is a continual competition among assets for capital. Every income producing or cash producing asset, including stocks, bonds, real estate, and annuities is affected by the level of interest rates. Not all assets have the same risk, so the rate applicable to equities will be different than Treasury Bonds, Corporate Bonds, and Convertible Bonds. This is simply a function of investors seeking the best returning asset per unit of risk.
As a result, the nearly 4-decade Bull Market in Bonds has provided an historic tail wind for all income generating assets. If and when interest rates start climbing again, the effect on asset values will be the opposite, a headwind and punishing BEAR MARKET.
From maturities of about 5 years to 30 years, Treasury rates are currently hovering either just below or just above 3%. As we discussed in our recent piece called “Inflection Point (Part 5)” (https://markonomics101.com/2018/09/03/inflection-point-part-5-interest-rates-inflation-and-inflection/), that level of 3%, appears to be substantially below the rate that one might expect. For example, the recently reported 12-month Consumer Price Index (CPI) of 2.9% suggests that Treasury Bond buyers are receiving no “real return”. Historically, real rates of return have been around 1%.
In addition, there is substantial anecdotal and mathematical evidence that the CPI substantially understates the annual increase in the cost of living. John Williams of Shadow Stats (http://www.shadowstats.com/) calculates a much higher rate for consumer inflation of more than 6% when he adjusts for the “alterations” that have been made over the last several decades to the “official” Government listed CPI. If his estimate is right, bond yields should be north of 7%.
The 3% level for Treasury Rates has proven to be a barrier of some length and significance. Five Year Treasury yields have remained below 3% for nearly a decade. Ten Year Treasury Yields have been held below 3% for 5 years and Thirty-Year Yields bel0w 3.25% for the last 3. A rise above these levels, while not catastrophic in and of itself, would establish a new trend of higher yields that will have a substantially depressing effect on both Stock and Bond Prices. So far, very little sign of inflation can be gleaned from the commodity markets which fell precipitously from 2008 and provided support for lower yields.
Even if inflation is not yet visible, the policy of The Federal Reserve to have maintained virtually 0% rates for nearly a decade will come with a heavy price. Interest rates serve to balance savings and investment, i.e., the amount available for lending and the amount sought for borrowing. By keeping rates artificially low, savers have been severely penalized, and borrowers incentivized to take excessive risk in order to create higher returns, at least temporarily. Who is the world’s biggest borrower? Uncle Sam. Who are forced to finance Uncle Sam’s profligate spending? We The People.
Last month, the Federal Government spent a whopping $433 Billion, a number which annualizes to $5 Trillion. At the same time, the monthly deficit was $214 Billion for an annual rate of $2.5 Trillion. The actual deficit will top $1 Trillion in fiscal 2019 despite RECORD tax collections. (https://www.zerohedge.com/news/2018-09-13/us-government-spends-record-433-billion-one-month-deficit-explodes).
If Williams’ number of 6% is correct, the annual cost to finance the National Debt would balloon to more than double its current annualized rate to about $500 Billion and join Medicare and Social Security as the Government’s Largest expenditures.
Not one person in Congress could or would in real life maintain a PERSONAL budget that looked anything like the Federal Government’s, so how on EARTH does this occur on such a massive scale at the Federal Level, putting the economy and financial system in peril? How do these 538 people pass such a budget, knowing full well that it is bad policy? Markonomics explains why:
From the 9 Laws of Markonomics (https://markonomics101.com/2018/07/08/the-9-laws-of-markonomics/)
Seventh Law: Establishing a Government is Preferable to Anarchy and Chaos. This Benefit is Offset by the Conflict of Interest between the collective-Interest of Society with the self-interests of those who serve in Government, pejoratively and accurately referred to as “Career Politicians”.
A Career Politician has the following characteristics: 1) NON STOP campaigning and money raising for additional terms of the same office or different offices, 2) seeks office even after one or more electoral defeats, 3) has had limited to no experience in the private sector (possibly never having actually held a paying job), 4) is primarily motivated by power and influence, 5) believes themselves to be “elite” or distinct from the constituency they represent, 6) believes the ends always justify the means, and 7) says one thing but does another. (If you’re a psychologist, what personality disorder shares many of these types of traits?)
Eighth Law: Career Politicians’ self-interest is to hold and retain office. Their self-interest is completely at variance with the collective-interest of Society.
Politicians’ self-interest is to maintain a permanent stranglehold on office either through election or re-election. This incentive is so counterproductive to “Society”, that it results in a variety of adverse effects such as corruption, fraud, use of misinformation to pass legislation, lying without repercussions, campaign funding (bribes) from sources whose interest are detrimental to society, the passage of detrimental legislation, regulation, tax laws, and a variety of unethical and illegal practices.
Unfortunately, the ramifications of bad economic policy are often felt years down the road, so the incompetent “Career Politicians” are never held accountable. They got re-elected, didn’t they?