InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
FEBRUARY 21 , 2018
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
Last week, we discussed derivatives trading in Volatility, and the role of that trading in the market turmoil of early February. In this issue of IntelDigest, we review other factors which will likely have great effect on the Economy and Markets going forward. Specifically, we address the current outlook on Inflation, Federal Borrowing, and Interest Rates.
We will certainly discuss each of these elements in much greater detail during 2018. For this briefing, let’s see where each stands today.
Inflation
The core annual rate of Inflation in the U.S. is just under 2%, which is right on target for the purposes of The Federal Reserve. There have not yet been signs of any appreciable increases in inflation in major sectors of the American Economy, such as housing or commodities or the equity markets (when low interest rates are factored in).
Since the 2008-2009 Financial Crisis, which threatened to sink world economies in a dangerous Deflationary spiral, central banks have pursued a policy of Extremely Low Interest Rates, coupled with unprecedented waves of money printing. This provided a flood of cheap money, with the goal of increasing Inflation by boosting corporate borrowing, increasing consumer spending, and elevating asset prices.
Although world economies have slowly recovered over the last nine years, Inflation (both general prices and wage inflation) has remained stubbornly low.
Low Inflation and Low Interest Rates have kept bond yields down, encouraging investors to move their money into the equities markets, where one could earn a comfortable dividend yield versus bond yields.
The result has been an unprecedented Bull Market in stocks. When the markets were roiled in early February, some analysts opined that the initial sell-off on February 2 was spurred by release of the monthly unemployment numbers, which showed evidence of wage inflation. One narrative was: Inflation is rising, so The Fed will raise interest rates and tighten monetary policy in order to “nip it in the bud.” That would choke off economic growth and tank the market.
They drew a direct line from Higher Inflation to Higher Interest Rates to investors abandoning equities for bonds and other commercial instruments which will start earning decent interest … like the Good Old Days.
However, the signs of some wage inflation are unlikely to upset the equity markets. The higher wages are primarily a result of stronger business metrics. The U.S. economy is expanding, and business owners have recently received the gift of lower income tax rates going forward. Businesses can afford to pay higher wages to attract quality employees. Higher wages will be more than offset by tax breaks and stronger business activity.
Although Inflation is expected to play a significant role in The Economy next year, we’re just not there yet.
Federal Government Borrowing
The Department of the Treasury recently announced that its 2018 borrowing requirements will be dramatically higher than last year. This is the first time in nearly a decade that Federal “debt issuance” has risen significantly.
This week, on the first day that the “floodgates” were opened, the government issued nearly $151 Billion of short-term Treasury bills, the largest single auction in history. The plan is to issue a total of $258 Billion of short-term and long-term debt this week.
This is just the beginning …
Congress and the Trump Administration have committed to rising budget deficits. The Federal government is expected to issue a mind-boggling $1.3 Trillion in new debt this year. This is a record amount … even more than the Obama Administration when it was working to pull the country back from the financial brink.
Debt issuance is expected to rise even further over the next few years.
To make matters worse, this new supply of government paper will hit the market at the same time that The Federal Reserve works to unwind its massive bond portfolio.
Economics 101: rising supply and falling demand results in lower bond prices. As bond prices and bond yields (interest rates) trade inversely, this suggests that interest rates will go a good deal higher over the next several years.
Interest Rates
As noted, the two greatest influences on Interest Rates are:
1. The United States Treasury must increase its borrowing dramatically, for this year and for several years into the future.
2. The Federal Reserve has signaled that it expects to raise short-term interest rates by 1.5%-2% (incrementally) over the next 24 months. And, it will seek to reduce its balance sheet by selling into the market Billions of Dollars of bonds which it has accumulated over the last nine years.
We have already experienced a significant increase in the 10-year Treasury note, which has doubled since the summer of 2016. It now stands at its highest rate in four years.
This is important, because the 10-year Treasury is a “benchmark” rate which affects a wide range of financial instruments, from mortgages to corporate bonds. Consequences of a higher 10-year Treasury include higher borrowing costs for … just about everybody!
Cheap credit has underpinned the equities markets, and allowed both corporations and governments to borrow huge amounts of money. The Debt Service on all that borrowed cash is about to become lots more expensive.
Interest Rates were expected to go higher this year. These recent developments indicate that rates could go much higher, sooner than expected.
Begin to Reduce the Risk in Your Portfolio
In these circumstances, we do not expect that The Fed will allow short-term rates to run up precipitously. However, The Fed does not control long-term rates … those are determined by markets. And, rising rates of any duration will eventually tip the Bull Market over.
Higher rates will cause businesses and consumers to decrease consumption, and some investors will begin to sell stocks and transition into safer government debt. That will suck the air right out of the U.S. stock market, and lead to the next recession.
So, investors who hold bonds must be cognizant of bond durations, and focus on bonds with shorter maturities.
And, begin to trim interest-rate sensitive stocks … primarily higher yielding stocks such as real estate investment trusts (REITs), utilities and energy stocks … which are often the first to lose value as Interest Rates rise.