Inflection Point (Part 5): Interest Rates, Inflation, and Inflection.
“Inflation” is the annual rate of price increase for a specific basket of goods or services a consumer buys and is directly tied to changes in “value” of the currency being used in the exchange of those goods and services. The government’s official gauge of inflation is the Consumer Price Index (CPI), which is put out monthly by the Bureau of Labor Statistics (BLS). The most recently reported annual CPI was 2.9% in July, which represents the price inflation over the previous 12 months (https://www.bls.gov/cpi/). The CPI calculations have been changed, altered, spindled, mutilated, and manipulated many times over the years. The stated need to alter the formula is to improve “accuracy”, so as to more closely represent the actual impact upon consumers.
However, incumbent administrations have used every excuse to keep reported inflation as low as possible. A substantial and growing portion of the budget, including Social Security, Medicare, Pensions, and Payrolls are annually “inflation adjusted”. Limiting the CPI-based escalation provides politicians with more available funds to wage war, or to keep Budget Deficits a bit lower.
The incentive to keep reported inflation artificially low doesn’t end with expenditures. The U.S. Government is the world’s largest borrower. A growing portion of the Budget is now “debt service”, the payment of interest to creditors. Annual interest expense is now in excess of $500 Billion.
The entire Federal National Debt exceeds $21.5 Trillion (http://www.usdebtclock.org/). Therefore, every additional one percent increase in rates could potentially add another $200 Billion per year to interest “payments” over time. If interest rates were to approach the “historical norms” of 5-6%, the annual “debt servicing” total expense would explode to more than $1 Trillion per year. When the CPI rate goes up and/or the Federal Reserve interest rates go up (which are directly tied to the CPI), the interest rates the Government must pay on newly issued debt securities (including Treasury Bonds) must also go up to keep pace. Every increase in interest expense is contractual and non-discretionary, leaving elected officials with less ability to alter the Budget.
The foremost expert of the techniques, adjustments, and mathematical tools used by the Bureau of Labor Statistics is John “Walter” Williams. Williams’ newsletter and website called “Shadow Stats” (http://www.shadowstats.com/), provides “alternate” estimates of official government data for key indicators such as Gross Domestic Product, Consumer Price Index, and Unemployment.
The red line, CPI-U, is the “unadjusted” or official number of the BLS. Williams’ “alternate” CPI (the blue line) employs the formula used by BLS in 1990, prior to the many adjustments. His alternate CPI has come in at well above 6% on average over the past 12 years.
An abundance of anecdotal evidence and COMMON SENSE supports Williams’ contention that the reported 2.9% CPI is, in reality, substantially lower than the level most individuals currently experience. Housing expense, most consumers’ single LARGEST, has been substantially outstripping reported inflation rates for decades (https://www.apartmentlist.com/rentonomics/rent-growth-since-1960/).
In fact, it’s difficult to come up with many categories of items NOT rising in price faster than inflation. Most items, such as health care, education, energy, entertainment, and housing are appreciating faster. Many private surveys seem to come to the very same conclusions: (https://www.msn.com/en-us/money/personalfinance/25-things-that-have-gone-up-in-price-way-more-than-inflation-in-the-us/ss-AAxrA9C.)
The rate of inflation is critical because it is the single most important factor that establishes the level of interest rates. In general, interest rates should reflect “inflationary expectations” PLUS provide for a small, but positive, rate of return. If Williams’ alternate CPI of 6% is accurate, then lenders ought to require the rate on 10 Year Treasuries to be roughly 7-8%, with the inclusion of a “real return” of 1-2% (CPI of 6% PLUS 1-2%).
Even if the “official” number of 2.9% is right, a yield that would compensate bond purchasers for inflation and yet add a small “real return”, would still be in the 4-5% range. Astonishingly, as can be seen in the charts below, both the 10 Year (TNX) and 30 Year (TYX) Treasuries have yields less than 3%. The last closing yield on the 10 Year Treasury was 2.85%, slightly BELOW the CPI.
There are only a few possible explanations for this discrepancy. One could be the market interfering operations of the Federal Reserve, whose mission it is to preserve price stability amid economic stability. Another would be the reflection of a FAR WEAKER economy than what is currently being reported. The most recent quarterly GDP estimates came in at a robust 4.2% annualized for the second quarter of 2018 (https://www.bea.gov/data/gdp/gross-domestic-product).
GDP growth is a combination of output growth AND price growth. A “nominal” or unadjusted GDP growth of 7% could be either comprised of 3% prices and 4% output or 6% prices and 1% real economic growth. Therefore, understating CPI by 3% is equivalent to OVERstating GDP by 3%. Are you starting to wonder why your personal experience consistently is far less sanguine than the government would have you believe?
The most recent quarterly GDP growth of 4.2% would, in reality, be 1.2%. The last decade’s reported average annual growth of approximately PLUS 1.5% would be more accurately reflected by a MINUS 1.5%. This too, would tend to be more consistent with our first hand experience. If Economic Growth HAS been been systematically overreported, it might also explain why the labor market was dismal during the same timeframe.
The markets, however, are the ultimate arbiters. If inflation, or its pre-cursors, are present, one market or another ought to reflect it. The next set of charts are of the financial instruments most likely to be sensitive to economic growth and inflation expectations. Precious Metal prices have historically been the most dependable hedge against a devaluing currency and overall price increases.
Gold (GLD) and Silver (SLV) have both turned recently BEARISH after breaking down from Triangles. These two provide corroboration that the economy is MUCH weaker than currently reported.
In addition, Treasury Inflation Protected Securities (TIPS), an Exchange Traded Fund which closely tracks inflation adjusted bonds, trades HIGHER if investors foresee increasing inflation. As inflation expectation rise, investors will require a greater yield premium for protection. TIPS do not currently reflect a high level of increasing inflationary expectations.
The US Dollar Index has traded within a narrow range of approximately 10% (91 to 101) for the last 4 years, hardly a sign of steady devaluation from inflation.
Interest rates are the dominant single factor in establishing valuations, both in absolute and relative terms among various asset classes. Higher interest rates, all other things being equal, mean lower asset values for everything: equities, real estate, businesses, fixed income, commodities, currencies, and even Cryptocurrencies.
Inflection Points are characterized by a broad shift in Market themes and preferences in response to new external realities. For more, see (https://markonomics101.com/2018/07/12/inflection-point-part-1-the-long-term-equity-valuation-cycle/) and (https://markonomics101.com/2018/07/15/inflection-point-part-2-financial-assets-give-way-to-hard-assets/).
Even if inflation remains contained, there will still remain upward pressure on interest rates. The 3% level for 10 Year and 30 Year Treasuries has held for several years. If those levels become exceeded, the Inflection will be complete, and investors will have to rapidly adjust to life in a “Rising Interest Rate” environment.