Category Archives: interest rates

The New Trump Economy

We have been talking about the “Plow Horse Economy” for quite a while now.  Low interest rates designed to spur economic growth have been offset by other government policies that have acted as a “Plow” holding the economy back.

Market watchers have assumed that the November election would see a continuation of those policies.  The general prediction was for slow growth, falling corporate profits, a possible deflationary spiral, and flat yield curves.

What a difference a week makes.  The market shocked political prognosticators by standing those expectations on their heads.

Bank of America surveyed 177 fund managers in the week following the elections who say they’re putting cash to work this month at the fastest pace since August 2009.

The U.S. election result is “seen as unambiguously positive for nominal GDP,” writes Bank of America Merrill Lynch Chief Investment Strategist Michael Hartnett, in a note accompanying the monthly survey. 

The stock market has reached several new all-time highs, moving the DJIA to a record 18,924 on November 15th, up 3.6% in one week.

Interest rates on the benchmark 10-year US Treasury bond have risen from 1.83% on November 7th to 2.25% today (November 17th), a 23% increase.  Expectations for the yield curve to steepen — in other words, for the gap between short and long-term rates to widen — saw their biggest monthly jump on record.

 WealthManagement.com says that

Global growth and inflation expectations are also tracking the ascent of Trump. The net share of fund managers expecting a stronger economy nearly doubled from last month’s reading, while those surveyed are the most bullish on the prospect of a pick-up in inflation since June 2004.

Investors are now also more optimistic about profit growth than they have been in 15 months.

Whether this new-found optimism is justified is something that only time will tell.  In the meantime to US market is reacting well to Trump’s plans for tax cuts and infrastructure spending.  Spending on roads, bridges and other parts of the infrastructure has been part of Trump’s platform since he entered the race for President.  It’s the tax reform that could be the key to a new economic stimulus.

According to CNBC American corporations are holding $2.5 trillion dollars in cash overseas. That’s equal to 14% of the US gross domestic product.  If companies bring that back to the US it would be taxed at the current corporate tax rate of 35%.  The US has the highest corporate tax rate in the world.  The promise of lower corporate tax rates – Trump has spoken of 15% – could spur the repatriation of that cash to the US, giving a big boost to a slow growth US economy.

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Inflation Ready to Rise

Brian Wesbury is one of our favorite economists and market commentators.  One of the key indicators the Federal Reserve is watching is the rate of inflation.  The Fed wants the “core” inflation rate to be 2%.  We are not in favor of any inflation at all, but we are not the Federal Reserve so it’s worth looking at the numbers they are looking at.

Wesbury:

The consumer price index is up only 1.1% in the past year. The Fed’s preferred measure of inflation – for personal consumption expenditures, or PCE – is up 1.0%. The US doesn’t face deflation, but the overall inflation statistics are, and have remained, low.

But the money supply is accelerating, the jobs market looks very tight, and underneath the calm exterior, there are some green shoots of inflationary pressure.

The “core” measures of inflation, which exclude volatile food and energy prices, are not nearly as contained as overall measures. And before you say everyone has to eat and drive, realize that both food an energy prices are volatile and global in nature. They don’t always reveal true underlying price pressures.

The ‘core” CPI is up 2.3% in the past year, while the “core” PCE index is up 1.7%. In other words, a drop in food and energy prices has been masking underlying inflation that is already at or near the Fed’s 2% target. Energy prices have stabilized and food prices will rise again. As a result, soon, overall inflation measures are going to be running higher than the Fed’s target.

Housing costs are up 3.4% in the past year and medical care costs are up 3.4%.

Although some (usually Keynesian) analysts are waiting for much higher growth in wages before they fear rising inflation, the fact is that wage growth is already accelerating. Average hourly earnings are up 2.6% in the past year versus a 2.0% gain only two years ago. Moreover, as a paper earlier this year from the San Francisco Fed pointed out, this acceleration is happening in spite of the retirement of relatively high-wage Baby Boomers and the re-entry into the labor force of workers with below-average skills.

But we don’t think wages cause inflation – money does. Inflation is too much money chasing too few goods. The Fed has held short-term interest rates at artificially low levels for the past several years while it’s expanded its balance sheet to unprecedented levels. Monetary policy has been loose.

… M2 has expanded at an 8.6% annualized rate. More money brings more inflation.

None of this means hyperinflation is finally on its way. In the past, inflation has taken time to build, leaving room for the Fed to respond by shrinking its balance sheet and getting back to a more normal monetary policy.

In the meantime, this will be the last year in a long while, where we see inflation below the Fed’s 2% target. Look for both higher inflation and interest rates in the years ahead.

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Negative Interest Rates – Searching for Meaning

We have mentioned negative interest rates in the past.  Let’s take a look at what it means to you.

Central banks lower interest rates to encourage economic activity.  The theory is that low interest rates allow companies to borrow money at lower costs, encouraging them to expand, invest in and grow their business.  It also encourages consumers to borrow money for things like new homes, cars, furniture and all the other things for which people borrow money.

It’s the reason the Federal Reserve has lowered rates to practically zero and kept them there for years.  It’s also why the Fed has not raised rates; they’re afraid that doing so will reduce the current slow rate of growth even more.

But if low rates are good for the economy, would negative interest rates be even better?  Some governments seem to think so.

Negative interest rates in Japan mean that if you buy a Japanese government bond due in 10 years you will lose 0.275% per year.  If you buy a 10 year German government bond today  your interest rate is negative 0.16%.   Why would you lend your money to someone if they guaranteed you that you would get less than the full amount back?  Good question.  Perhaps the answer is that you have little choice or are even more afraid of the alternative.

Per the Wall Street Journal:

There is now $13 trillion of global negative-yielding debt, according to Bank of America Merrill Lynch. That compares with $11 trillion before the
Brexit vote, and barely none with a negative yield in mid-2014.

In Switzerland, government bonds through the longest maturity, a bond due in nearly half a century, are now yielding below zero. Nearly 80% of Japanese and German government bonds have negative yields, according to Citigroup.

This leaves investors are searching the world for securities that have a positive yield.  That includes stocks that pay dividends and bonds like U.S. Treasuries that still have a positive yield: currently 1.4% for ten years.  However, the search for yield also leads investors to more risky investments like emerging market debt and junk bonds.  The effect is that all of these alternatives are being bid up in price, which has the effect of reducing their yield.

The yield on Lithuania’s 10-year government debt has more than halved this year to around 0.5%, according to Tradeweb. The yield on Taiwan’s 10-year bonds has fallen to about 0.7% from about 1% this year, according to Thomson Reuters.

Elsewhere in the developed world, New Zealand’s 10-year-bond yields have fallen to about 2.3% from 3.6% as investors cast their nets across the globe.

Rashique Rahman, head of emerging markets at Invesco, said his firm has been getting consistent inflows from institutional clients in Western Europe and Asia interested in buying investment-grade emerging-market debt to “mimic the yield they used to get” from their home markets.

Clients don’t care if it is Mexico or Poland or South Korea, he said, “they just want a higher yield.” ….

Ricky Liu, a high-yield-bond portfolio manager at HSBC Global Asset Management, said his firm has clients from Asia who are willing for the first time to invest in portfolios that include the highest-rated junk bonds.

How and where this will end is anybody’s guess.  In our view, negative interest rates are an indication that central bankers are wandering into uncharted territory.  We’re not convinced that they really know how things will turn out.  We remain cautiously optimistic about the U.S. economy and are staying the course, but we are not chasing yield.

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Interest rates around the world.

And you think that interest rates are low here?  You should be Japanese.

The Japanese people are paying the Japanese government to buy government bonds.  The rate on 10 year bonds is minus 0.159%.  Lenders are willing to pay the Japanese government for the privilege of getting back their principal, ten years from now.

Things are just slightly better in Germany.  The German government bond is yielding 0.025%.  That means if you lend the German government $1000 today they will give you back $1002.50 in ten years.

UPDATE:  June 14th, the morning the rate on the German bond has dropped to zero.

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