By Justin Pawl, CFA, CAIA, CFP®
Last Week Today.
- Christine Lagarde, the President of the European Central Bank, signaled increasing dovishness, including extending the bank’s bond purchase program.
- Retail sales for June exceeded forecasts, indicating that despite fading fiscal stimulus checks, the consumer remains in a position of strength and is willing to spend down some of the excess savings accrued during the Lockdown.
- June’s consumer inflation numbers were well above consensus. Core CPI rose 4.5% for the year (vs. 4.0% consensus), the most significant year-over-year increase since 1991. In looking at the data, much of the increase is related to pandemic adjustments that will subside. One area of the economy where prices may not fall back is housing inflation. The Bureau of Labor Statistics measures housing inflation using “Owners Equivalent Rent”, an imputed measurement that lags the market rate for housing.
- Nevertheless, due to base effects and reflation of prices, FHN Financial forecasts Core CPI will exceed 5% into 2022, which will make some people (including members of the Fed) nervous about monetary policy.
- Markets felt heavy last week and could not get anything going. Global equities only declined 0.6%, but fan favorites like the Nasdaq (-1.9%) and small-cap stocks (-5.1%) were quite a bit worse off. As noted above, inflation numbers came in hot, but interest rates declined for the week, a surprising result and the main topic of this week’s missive. Despite inflationary pressures, commodities were largely down for the week, though gold eked out a slight 0.2% gain. The US Dollar rose in anticipation of the Fed raising interest rates, though it does not appear to be in any rush to do so, and the VIX Index climbed above 20 in response to increased demand for downside S&P 500 hedges. For detailed weekly, monthly, and YTD asset class performance, click on the table below.
Interest Rates – Do They Have To Higher?
The economy is growing at the fastest rate in 50 years, corporate earnings are on fire, and inflation is at the highest level in the last 30 years. If you were presented with this set of circumstances at the end of the first quarter, would you forecast that interest rates would be higher or lower in the next three months? Common sense says that, of course, interest rates would be higher. One reason for expecting higher interest rates is that the Fed’s reaction to growing inflationary pressures has always been to raise the Federal Funds target interest rate and slow economic activity. Another reason it would be logical to expect higher interest rates is market-based. Namely, investors would not settle for negative real returns on bonds (i.e., earning a yield lower than the inflation rate). Instead, they would demand higher yields as compensation for lending money to the government (via the purchase of Treasury bonds).
Yet, the Fed is not acting to cool the economy, and the market is, thus far, dismissing the traditional signals that rates should be higher. On the first point, the Fed’s inaction was well telegraphed. After several years of studying monetary policy, Fed Chair Jerome Powell and his Federal Reserve team modified their monetary policy framework last summer. Without going into all of the details, the new policy framework can best be described as reactive instead of proactive. That is, the Fed will not adjust monetary policy based solely on forecasts, but instead, they will weigh their decisions more heavily on employment and inflation data they observe in real-time. Powell’s message to Congress this week underscores their new policy framework. Despite commentators (including members of Congress) insisting the Fed is wrong to maintain an accommodative monetary policy stance, Powell’s message to Congress was (thanks to Jim Vogel at FHN Financial for the excellent summary):
- The FOMC is entirely aware of all the facts and trends it is accused of ignoring.
- The FOMC has considered all the recent economic improvements. Its assessment of the data for policy changes addresses each one and has reasonable, calm replies for all of the concerns critics raise, grounded in economic analysis of today’s world and not 40-yr-old history.
- The central bank grasps the importance of its impact on growth and the financial markets, promising transparency rather than surprises.
But what about the “market”? Why aren’t investors demanding higher yields for putting their capital at risk? There are several popular explanations, the two most common being: the Fed’s Quantitative Easing program is distorting the market, and U.S. yields are still attractive to foreign buyers. There is, no doubt, some credence to these explanations. But there’s another potential explanation that is less popular – interest rates are low because there’s too much debt.
That’s the view of Lacy Hunt, the long-time economist of Hoisington Investment Management. While Hunt’s been accused of being a perma-bull on bonds, his consistent belief that rates will continue to move lower has been correct. And despite booming economic growth and spiking inflation, Hunt isn’t changing his forecast. Indeed, he believes the current GDP growth and inflation levels are the highest we’ll see for a very long time.
Hunt’s view is informed by extensive research, from which he concludes that when debt levels are already high, adding additional debt to an economy is subject to the law of diminishing returns. Initially, government debt can help stimulate economic growth, but once the debt burden gets too large, government spending is relatively ineffective and has only a temporary effect.
Hunt’s logic is straightforward, though heavily steeped in economic terms and formulae, so I’ll do my best to unpack it here. Let’s begin with the fundamental premise that as an economy becomes more indebted, the risk of default rises (both for the country and for its citizens). In light of the potential for rising default rates, banks must either charge a higher interest rate as compensation for the additional risk or stop extending loans to protect their balance sheet. In a very low interest rate environment, banks often cannot pass on higher rates to borrowers. Thus, when prevailing interest rates are low, banks hold onto an increasingly large percentage of their deposits. Those deposits are then directed to purchase safe assets like Treasuries and state-issued bonds to earn some level of interest on the cash. As a result, capital ends up in the less productive public sector instead of the private sector, which has a higher economic growth multiplier.
Not only is capital deployed inefficiently within the economy, but buying Treasuries and local government debt essentially traps capital inside the financial system and reduces the velocity of money. The velocity of money is a measurement of the number of times money moves from one entity to another. Simply stated, velocity is the number of times money changes hands in a year, and economic output (as measured by GDP) is equal to the Money Supply * Velocity. As money velocity declines, economic growth settles at a lower steady-state equilibrium. Slower economic growth, in turn, results in lower interest rates. While there is a plethora of academic research on highly indebted economies, one need only look to Japan to see the repercussions of excess debt levels on an advanced economy.
Central bankers’ ability to influence economic growth becomes one-sided when debt levels are high, and interest rates are low. The bankers still have tools to restrain growth (e.g., raising interest rates), but they are very limited in their ability to stimulate growth. The aftermath of the mortgage crisis in the U.S. provides a practical, relatively recent example. The Fed held interest rates at zero for seven years and expanded its balance sheet through several rounds of Quantitative Easing, yet GDP averaged only 2.3% from 2010 through 2015.
If monetary policy is no longer effective at stimulating growth, how do we get out of this economic quagmire? The answer, according to Hunt, is to reduce the debt overhang. A federal budget focused on reducing debt would initially diminish economic growth, but the debt level would come down over time, and the economy would recover. Yet, it’s difficult to imagine a democratic country adhering to a fiscal austerity program for long. It’s far easier for politicians to kick the can down the road and focus on re-election than to adopt programs that will initially harm their constituents, even if the program generates superior long-term results. So, while interest rates may move higher in the near term, Hunt believes interest rates are destined to go even lower as growing debt levels weigh on economic growth.