January 19, 2011
The conventional wisdom is that, after nearly 30 years of decline, U.S. interest rates have nowhere to go but up, and rising interest rates are bad news for bondholders, especially those who hold longer term maturities. (As rates rise, bond prices fall with the severity of the fall directly related to time to maturity.) This blog outlines existing upward and downward pressures on bond rates and outlines emerging issues which have the potential to turn into a dollar crisis.
Upward Rate Pressures
- The financial media believes that the U.S. economic recovery is finally taking off. Much of the data today indicate better economic performance, from holiday sales to better news on the jobs front. Fourth quarter GDP likely rose 3.5%, and the momentum may push first quarter growth toward 4%. The 2% social security tax cut for wage earners will likely help spur first quarter consumer spending (but after that, spending growth isn’t impacted until the 2% is taken away).
- The world’s economy appears to be growing, especially in the BRIC countries (Brazil, Russia, India, China) and the emerging markets. Added demand from a recovering U.S. economy will put upward pressure on resources, especially commodities, and is likely, at least initially, to put upward pressure on rates.
- Rates also rose in 2010’s fourth quarter with the implementation of the second phase of the Fed’s “Quantitative Easing” program (QE2). Bernanke, himself, indicated in his August address at the Kansas City Fed’s Jackson Hole meetings that one of the purposes of QE2, including the reinvestment of the cash interest payments and mortgage paydowns back into the markets, was to make sure Fed policy didn’t become passively tighter by allowing bank reserves to shrink when such cash payments were made. In effect, Bernanke indicated that the upcoming QE2 program was intended to keep long-term rates near their low points to “stimulate” housing and the economy. Today, with the run-up of more than 110 basis points (bps) (1.1 percentage points) in the 10 year Treasury, we know that QE2 did not accomplish that goal. I suspect that while some rate rise could be attributed to increasing worldwide economic activity and better prospects at home, much of that 110 bp rise was also due to widespread criticism of a QE2 policy that is simply monetizing trillions of dollars of new federal debt. More on this below.
Downward Rate Pressures
- U.S. Economic Growth faces headwinds:
o While the official headline unemployment rate (U3) is 9.4%, a more comprehensive definition (U6) puts the rate closer to 17%. And, using consistent definitions from the early 90s would put the rate closer to 22% (see www.shadowstats.com). While there appears to have been better news on the labor front of late, it is hard to see significant economic growth as long as such high levels of unemployment continue.
o To further exacerbate this, the new, GOP controlled, House of Representatives has spending restrictions as a major agenda item, which will slow economic activity by some multiple of the spending reduction.
o There is no longer any doubt that residential real estate is entering a second dip. Rising 10 year bond rates over the past 3 months have raised mortgage rates and made homes less affordable. The Case-Shiller index of home prices shows a definite downward movement in prices, and Shiller himself has indicated that the next leg down could be as large as 20%. Such a price movement will do two things: a) cause a negative “wealth effect” for continuing homeowners (this may amount to hundreds of billions of lost value), and b) it will accelerate the already rapidly rising trend in “strategic” defaults (people who can afford their mortgage payments who choose to walk away anyway).
o There remain huge fiscal issues at the state and local government levels. Most states are facing current budget deficits, but the poster child for kicking the can further down the road remains California. It prefers temporary patches, hoping that things will soon return to “normal”, i.e., pre-2008. Like the City of Chicago which sold its parking meters to Wall Street and some sovereign wealth funds for what appears to be significantly less than fair value, California is selling its state owned office buildings to raise some cash to partially patch its current deficit. The selling price appears low relative to the lease terms, but worse, the legislature is not dealing with the structural causes of the deficit. As a result, deficits are bound to reappear in future fiscal years. Wonder what happens when all of the salable assets have been sold?
o Clearly, more layoffs of state and local employees are coming. If not layoffs, then lower wages and benefits. In either case, this implies lower, not higher, levels of consumer spending.
o Finally, no one has addressed the huge level of unfunded liabilities in state pension plans. Because insolvency of the plans is not imminent, the politicians aren’t dealing with it. New Jersey’s governor, Chris Christie, who has done more than any other governor in pushing his state toward fiscal responsibility, has said that he simply has no idea about how to deal with the magnitude of the unfunded liability. Even if the current budget bleeding stops, it will be years of fiscal austerity and high levels of taxation to work out of these situations.
o Food costs have gone up rapidly in the U.S. (and in the rest of the world causing worries about social unrest in some underdeveloped countries). Gasoline prices, too, have risen rapidly in the past couple of months. And each cent takes some billions of dollars out of consumer disposable income. Higher food and energy prices will stunt economic growth and put downward pressure on rates.
- The World’s economy may slow.
o China has raised reserve requirements on their banks and put in other restrictions on real estate to try to deflate a growing real estate bubble. Today, if China sneezes, the rest of the world catches cold (we used to say this about the U.S.). And, if China slows, so will all of the commodity producers (Australia, Canada, Brazil, Russia …)
o The European debt crises is about to enter its third act – Portugal (Greece was Act I, Ireland was Act II). The debt crisis and the adoption of austerity throughout the continent will surely slow economic growth there. Furthermore, if the opposition party in Ireland wins the March elections (currently leading by 20 points in the polls), they have vowed to fix the sputtering Irish economy by removing much of the austerity via a “debt restructuring” (shorthand for “default”). If that occurs, it is likely that the rest of the European weaklings will follow suit. Surely, panic would spread worldwide, the dollar would strengthen, and interest rates would fall.
Given these headwinds, it is my view that if left to strictly market forces, deflation still has the upper hand. It may be several quarters or even years before the private sector of the U.S economy is healthy enough to grow on its own and for there to be upward pressure on interest rates generated by the domestic private sector.
The Flies in the Ointment
However, we no longer live in a world where the U.S. economy is dominant and unaffected by global events and conditions. A huge worry involves the seemingly wrongheaded monetary and fiscal policies currently being pursued in America. In an earlier blog, I commented on the level of debt and federal structural deficits (see “What Happens to the Cost of U.S. Debt if Interest Rates Rise?”, at Minyanville.com, November 29, 2010). The table below shows the largest six federal budget items (see www.USdebtclock.org), total federal spending, and total federal tax revenues.
|Category||Spending Rate (Mill $)|
|Total Federal Spending||$3,490,905|
|Total Federal Tax Revenue||$2,156,022|
These top six spending categories are centered around entitlements ($2.13 trillion), defense ($.7 trillion), and debt interest ($.2 trillion). The entitlements have been “untouchable” and Congress has kicked the can down the road on these issues for years. Currently, they seem to be ignoring the recommendations of Obama’s own Debt Commission. These six represent 86.6% of total federal spending, and 140.2% of total federal tax revenue. Even if all other discretionary spending were eliminated (about a 0% chance!), the structural deficit is $866 billion. Thus, the GOP proposals to ax $100 billion in spending (likely to be compromised downward significantly) barely makes a dent in the structural deficit. Given the tax “compromise” reached on Capitol Hill during the lame duck session of the 111th Congress, it appears that the structural deficit is growing, not shrinking. The question its, how long will the world be willing to finance these trillion plus dollar deficits at current interest rates? Most likely answer – not much longer unless Congress convinces investors that they are serious about spending and deficit reduction, and they can only do that by addressing the heretofore “untouchable” spending categories and by taking the Obama Debt Commission recommendations seriously.
The Fed, too, despite warnings from most of the world’s major central bankers and respected economic historians, has embarked upon monetary policies that have failed every time they have been tried. I am referring to the explosion of the Fed’s balance sheet which has led the huge levels of bank reserves and a monetization of almost all new Treasury debt. If you haven’t already viewed the You Tube rendition of “Quantitive Easing Explained” (www.youtube.com/watch?v=PTUY16Ck5-k), you should do so.
The Fed is not a true government agency. It is owned by the banking system and the Wall Street banks own the largest share. (So, it isn’t any wonder why the Fed was so anxious to save those institutions in ‘08 and ’09.) At the end of 2010, The Fed had $54 billion in capital. They recently announce net income of about $80 billion, of which $78 billion was returned to the Treasury. Their capital represents less than 2% of their assets (now approaching $3 trillion). In the U.S. banking system, once capital reaches 2% of assets, the Fed and the other regulatory agencies close the institution!
Given $1.25 trillion of mortgaged backed securities purchases in ’08 and’09, and the QE2 operations in the 4-7 year treasury maturity range, it appears that we can safely assume the Fed’s portfolio has at least a 5 year duration. Given that it would be nearly impossible to hedge a $3 trillion portfolio (market size), what would happen to the Fed’s finances if rates rose 100 basis points in the 5 year area of the yield curve? If the Fed had to “mark to market”, using the duration rule of thumb that for every 100 bp rise in rates results in a percentage fall in portfolio value equal to the duration, using $3 trillion as the asset size, the value of the portfolio would fall by $150 billion. Even if the Fed kept the entire $80 billion in profits, when added to its capital (about $51 billion at the end of ’09), it would still show negative equity.
Today, the Fed is not subject to public scrutiny and most likely doesn’t mark its portfolio to market. Enter Ron Paul. Paul is the new Chairman of the House Financial Securities subcommittee that oversees the Fed and monetary policy. It is no secret that he believes the Fed itself is unconstitutional. Herein lies the danger. Rates rose 110 bps from early November through early January in the 5 year segment of the curve, so significant damage may already have been done to the Fed’s capital. If the public audit advocated by Mr. Paul occurs and it shows that, on a mark to market basis, the Fed is insolvent, there may be a significant shift in attitude toward the dollar in the rest of the world, causing rates to rise with significant implications for the dollar as the world’s reserve currency, with negative implications for the domestic economy.
The probabilities are that interest rates will rise, not because of U.S economic expansion, but because of the disastrous fiscal and monetary policies that have been and are currently being pursued. Higher interest rates will occur as investors lose confidence in America and Treasury securities as a stable investment. The resulting rising interest rates will only make economic growth more difficult to achieve. History has shown that added debt and money printing have never reversed the effects of a debt bubble. Apparently, those in power in Congress and at the Fed either haven’t studied history, or actually believe that “this time is different”.
Robert Barone, Ph.D.
January 11, 2011
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