InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
FEBRUARY 28, 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.
We have written about the “Melt Up” in investment markets on several occasions over the last 18 months, and we continue to believe that high-quality equities (particularly banks and multinational corporations) are still buoyed by:
* improving economic conditions around the world
* strong earnings in many U.S. corporations
Corporate earnings are expected to sail for companies … both big and small … because of a new tailwind from the Tax Cuts and Jobs Act of 2017 (TCJA).
Interest Rates
However, we try to stay ahead of the trends, and the trend with respect to Interest Rates is changing as we go forward. As we have written on several occasions … most recently in our final 2017 post on December 20:
“…. we believe that the single most important factor in the current market climate is Interest Rates. While ultra-low rates have done immense damage to fixed-income investors over the last several years, investors in equities have done very well. There have simply been no easy options for investors, so they have invested heavily in stocks and stock funds, driving Price-to-Earnings Ratios to unusually high levels.”
The Federal Reserve (The Fed) has clearly signaled that it intends to alter this landscape, perhaps beginning as soon as next month. The Fed 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 since the Financial Crisis of 2008-2009.
Even though short-term rates would still be well below the historic norm, these combined actions will eventually create drag on economies and deflate equities markets.
Why Do Interest Rates Matter?
In addition to the actions of The Federal Reserve, the United States Treasury must increase its borrowing dramatically, for this year and for several years into the future. Cheap credit has underpinned the equities markets over the last eight years, 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.
The Debt Explosion
We wrote about the coming Debt Explosion in the December 20 issue:
* Government debt (both federal and state) has been growing exponentially in the last 17 years. Because the Federal Reserve cut interest rates to almost nothing, government borrowing costs have not exploded (yet!)
PLUS
* Consumer debt has returned to an all-time high (less than 10 years after a Financial Crisis which reverberated across the globe)
As we expect borrowing rates to continue rising over the next two years, much of this Debt will prove to be unsustainable and unserviceable.
Tax Breaks for All!
The aforementioned tax legislation … the Tax Cuts and Jobs Act of 2017 (TCJA) … is already contributing to the Debt Explosion. The new law lowers individual income tax rates, so new tax withholding tables went into effect this month.
The Congressional Budget Office (CBO) has estimated that withheld income taxes remitted to the U.S. Treasury will be $10-15 Billion less each month than in recent years. This was anticipated by Congress … the tax bill was passed under reconciliation rules which allowed reduction of revenue by $1.5 Trillion over 10 years, which works out to approximately $12.5 Billion per month.
The End of Low-Interest Treasury Borrowing
Because The Fed has pursued an ultra-low interest rate environment in the wake of the Financial Crisis, the federal government has been allowed to borrow tons of cash with minimal financing costs. The average interest paid on the U.S. Debt has been reduced to less than 2% in recent years.
Simply put: as interest rates increase, borrowing costs of the Treasury will rise. With total Treasury Debt of over $20 Trillion, even a 0.5% interest rate increase will impact the overall budget deficit.
As we wrote last week, Congress and the Trump Administration have committed to rising budget deficits. That’s what happens when you cut taxes and increase spending. The Federal government is expected to issue a mind-boggling $1.3 Trillion in new debt this year.
Add to that the doubling of Interest Rates over the next two years; and, the new supply of government paper which will hit the market at the same time as The Federal Reserve works to unwind its massive bond portfolio.
The result is a need for at least Two Trillion Dollars of additional funding for 2018 alone!
How Did We Get Here?
Most Americans have paid little attention to the massive increase in federal Debt over the last 17 years, primarily because ultra-low interest rates kept borrowing costs down. Even though total federal Debt outstanding has increased by 126% since 2008, borrowing costs have fallen over that period of time. The American public is paying about the same amount in annual interest as it did back in the early 1990s, when the national Debt was 80% less than it is today.
However, net interest payments started moving higher when The Fed began raising short-term rates two years ago. Today, federal interest payments exceed $260 Billion per year for the first time in history!
The Treasury Borrowing Advisory Committee (TBAC) is a group of private banks which advises the Treasury Department. TBAC has estimated that the Treasury would need to borrow approximately $955 Billion in the fiscal year that ends September 30, up substantially from $519 Billion in the previous fiscal year. The TBAC estimate for fiscal 2019 is $1.083 Trillion; for fiscal 2020, $1.128 Trillion.
The Treasury has also announced that it will shift from predominantly longer-term bonds (average duration of 70 months) to more short-term Debt. Ostensibly, this shift will help offset the reduction in demand for longer-term debt by The Federal Reserve, as it unwinds its bond portfolio. However, there could be serious consequences to this policy.
First, the additional supply of short-term debt will push short-term rates even higher, and hasten the yield curve “inversion” that historically triggers a recession. And, the problem of government borrowing costs could be made exponentially worse.
Instead of being able to lock in long-term interest costs on longer-term bonds (even though the Treasury would be committed to paying higher rates on those bonds), the Treasury will have to constantly reissue short-term Debt at rates which begin low, but grow higher and higher over the years.
Next week, we will discuss re-positioning some portfolios in light of these developments.