Category Archives: interest rates

Macroeconomics for Professionals

July 31, 2019 By in administration economic strategy, economics, fed funds rate, Federal Reserve, macroeconomics, Strategy, Uncategorized Tags: , , , , , , 3 Comments

Starting-out note:  there’s an investment idea in here eventually.

I’ve been going through Macroeconomics for Professionals:  a Guide for Analysts and Those Who Need to Understand Them, written by two IMF professionals, with the intention of giving it, or something like it, to one of my children who’s getting more interested in stock market investing.  I’m not finished with the book, but so far, so good.

counter-cyclical government policy

The initial chapter of MfP is about counter-cyclical government policy, a topic I think is especially important right now.

Picture an upward sloping sine curve.  That’s a stylized version of the pattern of economic advance and contraction that market economies experience.  Left to their own devices, the size of economic booms and subsequent depressions tend to be very large.  The Great Depression of the 1930s that followed the Roaring Twenties–featuring a 25% drop in output in the US and a decade of unemployment that ranged between 14%-25%–is the prime example of this.  National governments around the world made that situation worse with tariff wars and attempts to weaken their currencies to gain a trade advantage.  A chief goal of post-WWII economics has been to avoid a recurrence of this tragedy.

The general idea is counter-cyclical government policy, meaning to slow economic growth when a country is expanding at a rate higher than its long-term potential (about 2% in the US) and to stimulate growth when expansion falls below potential.

 

applying theory in today’s Washington

Entering the ninth year of economic expansion–and with the economy already growing at potential–Washington, which had provided no fiscal stimulus in 2009 when it was desperately needed, decided to give the economy a boost with a large tax cut. Although pitched as a reform, with lower rates offset by the elimination of special interest tax breaks, none of the latter happened.  Then, just a few days ago, Washington gave the economy another fiscal boost.  Mr. Trump, channeling his inner Herbert Hoover, is also pressing for further interest rate cuts to achieve a trade advantage through a weakened dollar.

This is scary stuff for any American.  The country faced a similar situation during the Nixon administration, which exerted pressure on the Fed to keep rates too low during the early 1970s.  Serious economic problems that this brought on didn’t emerge until several years later, when they were compounded by the second oil shock in 1978 (that was my first year in the stock market; I was a fledgling oil analyst).

why??

Why, then, is Mr. Trump trying to juice the US economy when he should really be trying to wean it off the drug of ultra-low rates?

I think it’s safe to assume that he doesn’t understand the implications of what he’s doing (the thing Americans of all stripes recognize, and like the least, about Mr. Trump, a brilliant marketer, is how little he actually knows).   If so, I can think of two reasons:

–as with many presidents a generation ago, he may see ultra-loose money as helping his reelection bid, and/or

–the “easy to win” trade wars may be hurting the US economy much more deeply than he expected and he sees no way to reverse course.

If I had to guess, I suspect the latter is the case and that the former is an added bonus.  I think the main counter argument, i.e., that this is all about the 2020 election, is that the administration seems to be systematically eliminating any parties/agencies that want to investigate Russian interference in domestic politics.

Either would imply that software-based multinational tech companies that have led the stock market for a long time will continue to be Wall Street winners–and that the weakness they are currently experiencing is mostly an adjustment of the valuation gap (which has become too large) between them and the rest of the market.

In any event, interest rate-sensitives and fixed income are the main areas to avoid.  If the impact of tariffs is an important motivating factor, then domestic businesses that cater to families with average or below-average incomes will likely be hurt the worst.

 

 

 

 

cutting the fed funds rate

July 16, 2019 By in Federal Reserve, interest rates, Uncategorized Tags: , , , 1 Comment

The main value you and me in Mohamed El-Erian’s observations on financial markets is that he has a knack for framing accurately, if longwindedly, the consensus view of financial professionals on topics of the day.  Nothing profound, but a solid base for figuring out how to fashion contrary bets.

In a piece for Yahoo Finance this week, however, Mr. El-Erian has neatly made a number of points about the fed funds rate cut that seems to be on the cards for later this month:

–there’s little justification for the cut on traditional economic grounds

–the reduction will likely have little impact on the real economy

–the cut won’t weaken the dollar, because other nations will reduce their equivalent rates

–at a time when financial speculation is already running hot, a rate cut risks adding accelerant to the fire

–cuts reduce the scope for the Fed to act in case of a real financial emergency

–the Fed will lose at least some credibility as an independent body whose signals should be followed by financial markets (my note: in fact, the parallels are already being drawn between Trump and Nixon, whose meddling with the Fed for political reasons in the early 1970s led to financial disaster later in that decade).

no good reason to cut, so why?

If everything’s going so well, why bully the Fed into easing?

I think it has to do with stock market earnings growth.  Last year overall eps for the S&P 500 grew by about 18%.  My back-of-the-envelope estimation is that operating earnings grew by 8% and the other 10% was a one-time upward adjustment for lower US taxes.  A reasonable guess for 2019–without including the negative effect of tariffs–would have been another 8% growth for the US portion of S&P earnings and, say, 6% for the foreign component.  Figuring that both are roughly equal in size, that would imply +7% for 2019 eps.

So far, though, eps are coming in about flat. And analyst predictions, always on the sunny side, are now for slight year-on-year dips for the June and September quarters.  Yes, Europe is weaker than one might have thought.  So that’s a (small) part of the disappointment.  But it seems to me the Trump tariffs + retaliation to them must be biting much deeper into the domestic economy than Wall Street (or I) had been expecting.   …and that’s without considering the longer-term structural harm I think they are likely to do.

If so, the solution is to find a face-saving way to reduce or eliminate tariffs.  it is certainly not to introduce further distortions into fixed income markets.

PS:  it seems to me that the best way to compete with China is to strengthen the education system and to support government-assisted scientific research.   Both are non-starters in today’s domestic politics.

 

 

 

Trump and the Federal Reserve

April 10, 2019 By in Federal Reserve, interest rates, Strategy, Uncategorized Tags: , , , 1 Comment

dubious strategies…

I was thinking about last year’s Federal government shutdown the other day.  There are two million+ Federal workers.  They make an average salary of just above $90,000 a year, which is 50% more than the typical worker in the US.   Add in health insurance and pension benefits and their total compensation is double the national average.

On the surface, it seems odd to me that Federal workers began to run out of money almost the minute Mr. Trump laid them all off late last year.  On second thought, though, given their apparent job security and generous benefits, there’s arguably no urgent reason for them to build up savings.  Maybe they do live at what for others might be right on the edge.

That might explain the outsized negative impact laying Federal workers off en masse had on the economy, given that they represent only about 1.3% of the workforce?  If each consumes as much as two average workers, which I think is a reasonable guess, then the layoff does the same damage as 2.5% of the total American workforce becoming unemployed.

This is bigger than you might think.  A 2.5% rise in unemployment is what happens in a garden-variety recession.  No wonder the economy appeared to fall off a cliff in January.

 

Consider, too, the effect of the Trump decision to withdraw from international associations in favor of waging country-to-country trade warfare.  The resulting flurry of highly targeted tariffs and retaliatory counter-tariffs has made the US, at least for the moment, a uniquely bad place for new capital investment.  That’s even without considering the administration’s policy of restricting domestic firms’ ability to hire highly talented foreign technicians and executives–a policy that has made Toronto the fastest-growing tech city in North America.  Again, no surprise that new domestic capital additions sparked by tax cuts have fallen far below Washington estimates.  And, of course, tariff wars have lowered demand for US goods abroad and raised prices of foreign goods here.

My point is that–apart from the ultimate merits of administration goals–they are being pursued in a strikingly shoot-yourself-in-the-foot way.

…continue

Yes, Federal workers are back on the job.  I can’t imagine that they will resume their old spending habits, though, given the new employment uncertainty they are facing.  Last week the administration discussed disrupting the supply chains of American multinationals with operations in Mexico.  Yesterday, the talk was of a possible $11 billion in new tariffs on imports from the EU …and the retaliation that would surely follow.  Even if none of this materializes, their possibility alone will increase the reluctance of companies to operate inside the US.  The negative effect of all this may be much greater than the consensus thinks.

 

now the Federal Reserve

This central bank’s official role is to set monetary policy through its control of short-term interest rates.  Its unoffical role is to be a political whipping boy.  It takes the blame for (always) unpopular rises in interest rates that are needed to keep the economy from overheating, and on track to achieve maximum sustainable long-term GDP growth.

The two instances where the Fed has succumbed to Washington arm-twisting–the late 1970s and the early 2000s–have created really disastrous outcomes, the big recessions in 1981 and 2008.

Despite this, Mr. Trump has apparently decided to offset the negative economic effects of his tax and trade policies, not by stopping doing what’s causing harm, but by forcing the Federal Reserve into an ill-advised reduction in interest rates.  His first step down this road will apparently be the nomination of two loyalists without economic credentials to fill open seats on the Fed’s board.

If the two, or similar individuals, are nominated and confirmed, the likely result will be a decline in the dollar, the start of a residential real estate bubble and a further shift of corporate expansion plans away from the US.  We may also see the beginnings of the kind of upward inflationary spiral that plagued us in the late 1970s.

 

investment implications

Replying to a comment on my MMT post, I wrote:

“Ultimately, though, the results would be a loss of confidence, both home and abroad, that lenders to the government would be paid back in full. That would show itself in some combination of currency weakness, accelerating inflation and higher interest rates. Typically, bonds and bond-like investments would fare the worst; investments in hard-currency assets or physical assets like real estate/minerals, or in companies with hard-currency revenues would fare the best. I think gold, bitcoin and other cryptocurrencies would go through the roof.”

I think the same applies to Mr. Trump gaining control over the Fed.

 

 

 

 

 

 

 

 

 

 

 

threatening Federal Reserve independence

January 10, 2019 By in currency effects, economics, Federal Reserve, government economic policy, interest rates, reserve currency, Uncategorized Tags: , , , , , , , 4 Comments

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

 

 

 

 

 

 

a US market milestone, of sorts

May 16, 2018 By in currency effects, currency markets, Current Market Thoughts, interest rates, Strategy, Uncategorized Tags: , , , , 1 Comment

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.