This is the second installment of the current bond market outlook of Denis Jamison of Strategy Managers, LLC. The first installment appeared yesterday.
Free money…
…at least until 2014 according to the Federal Reserve. They just about guaranteed they will maintain the current zero to 0.25% Federal Funds rate until early 2014.
When the financial crisis began to unfold in 2008, the Federal Reserve responded by flooding the monetary system with credit. Now, they have a new gambit in their efforts to push consumers and businesses toward more spending – a low interest rate guarantee. The Fed seems to be taking the role of the real estate salesperson getting you to buy a house you can’t afford by offering a temporarily low mortgage rate or the car dealer looking to reduce inventories by providing zero percent financing. As Yogi Berra said after seeing back-to-back homers by Maris and Mantle, “it’s déjà vu, all over again.” Wasn’t it the mispricing and misallocation of capital that got us here in the first place?
Excess liquidity creates bubbles either in the real economy or the financial markets. Right now, the benefits of low interest rates and surplus central bank credit have flowed to the financial markets and the big commercial banks. Market participants know the Fed is behind the curve on its interest rate policy. Based on a formula derived by Stanford University economist John Taylor, the current short-term interest rate should be 0.65%. That, however, is based on trailing core CPI of just 1.9% and the current unemployment level of 8.2%. It’s reasonable to assume that core CPI will trend higher -CPI including food and energy prices is already 2.7% – and the unemployment rate will gradually respond to 2%-plus GDP growth. If you plug 2.25% inflation and 7.5% unemployment into the professor’s formula, you come up with a Federal Funds target of 1.8%. How we get there from here is anyone’s guess. But it’s very hard to get the air out of bubbles – financial or otherwise – without a pop.
Go Straight Ahead
When you reach $5 trillion, make a sharp left. That appears to have been the roadmap for the federal government’s debt expansion. From 1970 until 2008, the outstanding debt grew about 3.5% yearly and reached about $5 trillion. (In the Fifties and early Sixties, the annual increase was less than 1 %.) Direct federal government debt is now $10.4 trillion or about 68% of nominal GDP. (This only includes public debt outstanding. It doesn’t include the $4.7 trillion of inter-government holdings – otherwise known as the Social Security Trust Fund – theoretically owed by the federal government .) With the government’s debt burden growing at 11% a year and nominal GDP expanding 4% to 5%, debt could top GDP within six years.
That’s the point of no return – the debt trap. From that point forward, the cost of funding the national debt will grow faster than the economy.
There are only two ways to escape the debt trap: budget austerity or currency devaluation. So far, our elected officials appear to be unwilling to address the first alternative – and for good reason. Most of the money is spent on folks who vote. Social Security, Medicare and Medicaid account for 44% of total outlays. The defense budget grabs another 24% and social welfare spending – mostly going to state and local governments – claims another 12%. That’s 80% of the total. (Meanwhile, the small 6% slice going to pay the interest on the national debt will likely balloon over the next few years.) Devaluation is tricky – but much more doable. If inflation can be pushed higher, the nominal value of everything real goes up and the actual value of debt goes down. It’s worth remembering from 1974 through 1981, nominal GDP grew at a 10% annual rate despite two recessions. Little of this growth was real – inflation adjusted GDP averaged just above 2% a year –but it sure lowered everyone’s debt burden. In that regard, it’s worth citing a quote from Adam Smith, “All money is a matter of belief.”
Keeping a Low Profile
We continue to keep the effective maturity of our clients portfolio’s below that of their benchmarks. This served us well during the March quarter and the accounts tended to outperform their benchmarks. It is worth noting, however, that a bearish stance in a bear market does not necessarily mean you make money. Good relative performance does not mean good absolute performance. During 2011, long-term U.S. Treasury bonds returned nearly 30% and the mortgage market recorded an 8% gain. We expect most of those outsized increases to be reversed this year. Given the low absolute level of coupon income for most bonds, even a small increase in interest rates will translate into a negative total return. The current year promises to be quite difficult for most bond investors.