Tag Archives: Federal Reserve

How interest rates are determined

From our favorite economist – Brian Wesbury:

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined.

Lots of this confusion has to do with the role of central banks. Many think central banks, like the Fed, control all interest rates. This isn’t true. They can only control short-term rates. It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time. If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future.

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation. Credit risk – the chance a loan will not be repaid – is also part of any interest rate. And, of course, those who earn interest owe taxes on that income. After taxes, investors deserve a positive return. In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they? In July 2012, the 10-year Treasury yield averaged just 1.53%. But since then, the consumer price index alone is up 1.5% per year. An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes. In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off. The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing. The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand. But this is a mistake. Bonds aren’t like commodities, where if someone buys up all the steel, the price will move higher. A bond is a bond, no matter how many exist. Just because Apple has more bonds outstanding than a small cap company doesn’t mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)? It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon. It should have the same yield. It didn’t become a collector’s item; it still faces competition from a wide array of other investments. It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future. If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero. And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well. The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing. That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise. Why? Because the Fed has held short-term rates too low for too long. Interest rates are below inflation and well below nominal GDP growth. The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow. Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher. It’s true the Fed is unwinding QE, but that’s not why rates are going up. They’re going up because the economy is telling savers that they should demand higher rates.

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Don’t Fear Higher Interest Rates

Here’s some weekly commentary from Brian Wesbury of First Trust 

The Federal Reserve has a problem.  At 4.1%, the jobless rate is already well below the 4.6% it thinks unemployment would/could/should average over the long run.  We think the unemployment rate should get to 3.5% by the end of 2019 and wouldn’t be shocked if it got that low in 2018, either.

Add in extra economic growth from tax cuts and the Fed will be worried that it is “behind the curve.”  As a result, we think the Fed will raise rates three times next year, on top of this year’s three rate hikes, counting the almost certain hike this month.  And a fourth rate hike in 2018 is still certainly on the table.  By contrast, the futures market is only pricing in one or two rate hikes next year – exactly as it did for 2017.  In other words, the futures markets are likely to be wrong for the second year in a row.

And as short-term interest rates head higher, we expect long-term interest rates to head up as well.  So, get ready, because the bears will seize on this rising rate environment as one more reason for the bull market in stocks to end.

They’ll be wrong again.  The bull market, and the US economy, have further to run.  Rising rates won’t kill the recovery or bull market anytime in the near future.

Higher interest rates reflect a higher after-tax return to capital, a natural result of cutting taxes on corporate investment via a lower tax rate on corporate profits as well as shifting to full expensing of equipment and away from depreciation for tax purposes.

Lower taxes on capital means business will more aggressively pursue investment opportunities, helping boost economic growth and the demand for labor – leading to more jobs and higher wages.  Stronger growth means higher rates.

For a recent example of why higher rates don’t mean the end of the bull market in stocks look no further than 2013.  Economic growth accelerated that year, with real GDP growing 2.7% versus 1.3% the year before.  Meanwhile, the yield on the 10-year Treasury Note jumped to 3.04% from 1.78%.  And during that year the S&P 500 jumped 29.6%, the best calendar year performance since 1997.

This was not a fluke.  The 10-year yield rose in 2003 and 2006, by 44 and 32 basis points, respectively.  How did the S&P 500 do those years: up 26.4% in 2003, up 13.8% in 2006.

Sure, in theory, if interest rates climb to reflect the risk of rising inflation, without any corresponding increase in real GDP growth, then higher interest rates would not be a good sign for equities.  That’d be like the late 1960s through the early 1980s.  But with Congress and the president likely to soon agree to major pro-growth changes in the tax code on top of an ongoing shift toward deregulation, we think the growth trend is positive, not negative.

It’s also true that interest on the national debt will rise as well.  But federal interest costs relative to both GDP and tax revenue are still hovering near the lowest levels of the past fifty years.  As we’ve argued, sensible debt financing that locks in today’s low rates would be prudent. However, it will take many years for higher interest rates to lift the cost of borrowing needed to finance the government back to the levels we saw for much of the 1980s and 1990s.  And as we all remember the 80s and 90s were not bad for stocks.

Bottom line: interest rates across the yield curve are headed higher.  But, for stocks, it’s just another wall of worry not a signal that the bull market is anywhere near an end.

 

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Time To Drain The Fed Swamp

The Panic of 2008 is widely misunderstood.  Part of this is due to the fact that financial issues are complicated.  How many people, after all, know what “mark to market accounting” is?  Part of it is due to politics.  Government policies encouraged home ownership by lowering lending standards, leading to NINA (“No Income No Assets”) loans.  At one time home prices were rising so fast that people believed that no matter what they paid for a house they could always sell it for more.

A thought-provoking article by Brian Wesbury of First Trust expands on this issue.

 Time To Drain The Fed Swamp

The Panic of 2008 was damaging in more ways than people think. Yes, there were dramatic losses for investors and homeowners, but these markets have recovered. What hasn’t gone back to normal is the size and scope of Washington DC, especially the Federal Reserve. It’s time for that to change.

D.C. institutions got away with blaming the crisis on the private sector, and used this narrative to grow their influence, budgets, and size. They also created the narrative that government saved the US economy, but that is highly questionable.

Without going too much in depth, one thing no one talks about is that Fannie Mae and Freddie Mac, at the direction of HUD, were forced to buy subprime loans in order to meet politically-driven, social policy objectives. In 2007, they owned 76% of all subprime paper (See Peter Wallison: Hidden in Plain Sight).

At the same time, the real reason the crisis spread so rapidly and expanded so greatly was not derivatives, but mark-to-market accounting.

It wasn’t government that saved the economy. Quantitative Easing was started in September 2008. TARP was passed on October 3, 2008. Yet, for the next five months markets continued to implode, the economy plummeted and private money did not flow to private banks.

On March 9, 2009, with the announcement that insanely rigid mark-to-market accounting rules would be changed, the markets stopped falling, the economy turned toward growth and private investors started investing in banks. All this happened immediately when the accounting rule was changed. No longer could these crazy rules wipe out bank capital by marking down asset values despite little to no change in cash flows. Changing this rule was the key to recovery, not QE, TARP or “stress tests.”

The Fed, and supporters of government intervention, ignore all these facts. They never address them. Why? First, institutions protect themselves even if it’s at the expense of the truth. Second, human nature doesn’t like to admit mistakes. Third, Washington DC always uses crises to grow. Admitting that their policies haven’t worked would lead to a smaller government with less power.

The Fed has become massive. Its balance sheet is nearly 25% of GDP. Never before has it been this large. And yet, the economy has grown relatively slowly. Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly.

So how do you drain the Fed? By not appointing anyone that is already waiting in D.C.’s revolving door of career elites. We need someone willing to challenge Fed and D.C. orthodoxy. If we had our pick to fill the chair and vice chair positions (with Stanley Fischer announcing his departure) we would be focused on the likes of John Taylor, Peter Wallison, or Bill Isaac.

They would bring new blood to the Fed and hold it to account for its mistakes. It’s time for the Fed to own up and stop defending the nonsensical story that government, and not entrepreneurs, saved the US economy. Ben Bernanke and Janet Yellen have never fracked a well or written an App. We need a government that is willing to support the private sector and stop acting as if the “swamp” itself creates wealth.

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When is the Next Recession?

One of our favorite market analysts, Brian Wesbury – who coined the term “Plow horse Economy” to describe the current economic situation – has been accused of being a “perma-bull” because he had discounted all the predictions of recession over the last 7 1/2 years.  We can understand why people are concerned about recessions because 2008 is still fresh in our minds.  The recovery that began in 2009 has been anemic.  Millions of people have not seen their financial situation improve.

Remember fears about adjustable-rate mortgage re-sets, or the looming wave of foreclosures that would lead to a double-dip recession? Remember the threat of widespread defaults on municipal debt? Remember the hyperinflation that was supposed to come from Quantitative Easing? Or how about the Fiscal Cliff, Sequester, or the federal government shutdown? Or the recession we were supposed to get from higher oil prices…and then from lower oil prices? How about the recession from the looming breakup of the Euro or Grexit or Brexit?

None of these things has brought on the oft-predicted recession.  Wesbury says that at some point a recession will come.  We have not reached the point where fiscal or economic policy has eliminated that possibility.  He mentions several indicators, including truck sales and “core” industrial production as indicators that should be watched.

Meanwhile,

Job growth continues at a healthy clip. Initial unemployment claims have averaged 261,000 over the past four weeks and have been below 300,000 for 80 straight weeks. Consumer debt payments are an unusually low share of income and consumers’ seriously delinquent debts are still dropping.   Wages are accelerating. Home building has risen the past few years even as the homeownership rate has declined, making room for plenty of growth in the years ahead.

Meanwhile, there haven’t been any huge shifts in government policy in the past two years. Yes, policy could be much better, but the pace of bad policies hasn’t shifted into overdrive lately.

In other words, our forecast remains as it has been the past several years, for more Plow Horse economic growth.   But you should never have any doubt that we are constantly on the lookout for something that can change our minds.

While the next recession may or may not be right around the corner, serious investors should be prepared for the eventuality so that when it does arrive, they will be ready.   We invite your inquiries.

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Keeping Your Eye on the Ball

Investors face a fire-hose torrent of information every day.  Determining what’s important and what’s irrelevant is critical.  Projections of doom and gloom are interspersed with promises of fabulous wealth if only we invest in a certain way.  99% of it is useless or even counter-productive, meant to entice the unwary investor to chase after chimeras that are simply not real.

Today’s issue of First Trust’s Monday Morning Outlook:

Honest question: How much time does the Apple Inc. Board of Directors spend debating whether the Federal Reserve will hike rates once or twice more in 2016?  We don’t really know the answer, but we would guess the best answer is zero.

Now, how much time does CNBC spend debating this question, along with potential actions of the Japanese and European Central Bank?  Answer: Way, way too much.

Business news should cover business, not government, but somehow, over the years, people have been led astray and many now think actions by the government are more important than actions of businesses and entrepreneurs.  Nothing could be further from the truth…

So, while the TV debates between day traders rage on, it doesn’t really matter whether the Fed lifts rates in June, or not.  The difference between a 0.5% and 0.75% federal funds rate matters little to corporate America and entrepreneurs.  In fact, higher rates will most likely make money more available, not less.  If the Fed really wanted to tighten policy, it would get rid of all excess reserves, but it won’t.  So, we suspect a symbolic rate hike in June, no matter what the talking heads’ endless debates about the matter suggest.

As investors we want to follow the lead of Boards of Directors, not the lead of what passes for business journalism these days.  No matter what they say, it is the entrepreneurial class that drives economic activity, not the government.

After all, Greenspan, Bernanke and Yellen have never pulled all-nighters drinking Red Bull and writing Apps for the iPhone.  That’s what changes lives, not quarter point rate hikes.

Professional investors have learned the difference between meaningful information that has a real impact on portfolios and simple distractions.  If you are interested in seeing how this process works, contact us.

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How is the US Treasury managing the nation’s debt?

With interest rates at or near historic lows a lot of people are taking advantage of low rates to re-finance their debts.  Is the US Treasury taking this opportunity to lock in low rates?  Not really.

Here is First Trust’s commentary on the issue.

Instead of imposing strict fiduciary rules on Wall Street, banks, investment houses, and financial advisors, the government should apply similar rules to the managers of the federal debt. This is particularly true because unlike the private sector – which faces tough market competition every day – the debt managers at the Treasury Department have a monopoly.

These federal debt managers have been flagrantly violating what should be their fiduciary responsibility to manage the debt in the best long-term interests of the US taxpayer.

Despite a roughly $19 trillion federal debt, the interest cost of the debt remains low relative to fundamentals. In Fiscal Year 2015, interest was 1.2% of GDP and 6.9% of federal revenue, both the lowest since the late 1960s. To put this in perspective, in 1991 debt service hit a post-World War II peak of 3.2% of GDP and 18.4% of federal revenue.

In other words, for the time being low interest rates have kept down the servicing cost of the debt even as the debt itself has soared.

You would think that in a situation like this, with federal debt set to continue to increase rapidly in the future, that the government’s debt managers would bend over backwards to lock-in current low interest rates for as long as possible.

But you would be wrong. The average maturity of outstanding marketable Treasury debt (which doesn’t include debt held in government Trust Funds, like Social Security) is only 5 years and 9 months. That’s certainly higher than the average maturity of 4 years and 1 month at the end of the Bush Administration, but still way too low given the level of interest rates.

The government’s debt managers have a built-in bias in favor of using short-term debt: because the yield curve normally slopes upward, the government can save a little bit of money each year by issuing shorter term debt. In turn, that means politicians get to show smaller budget deficits or get to shift spending to pet programs.

But this is short-sighted. The US government should instead lock-in relatively low interest rates for multiple decades, by issuing more 30-year bonds, and perhaps by introducing bonds the mature in 50 years or even longer.

At present, we find ourselves in the fortunate situation of being able to easily pay the interest on the federal debt. But this isn’t going to last forever. If the government locks-in low rates for an extended period it would give us time to catch our breath and fix our long-term fiscal problems, like Medicare, Medicaid, and Social Security.

There’s no reason this has to be a partisan issue. The government’s debt managers should just treat the debt like it’s their own. If the government is determined to hold many others to a stricter standard, it should lead by example.

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Wall Street down following Fed comments

From Reuters:

Wall Street dropped on Wednesday after the U.S. Federal Reserve frustrated investors hoping for a strong sign it might scale back future interest rate hikes because of recent financial and economic turmoil.

In a widely expected decision, the Fed kept interest rates unchanged and it said it was “closely monitoring” global economic and financial developments, but it maintained an otherwise upbeat view of the U.S. economy.

This morning Art Cashin predicted :

That, I think, will make them [the Fed] very reluctant to say anything that might look like a full mea culpa or a rethink. Therefore, I think the statement will say they remain flexible and data dependent and that they are aware of crosscurrents. Let’s see if that’s enough to boost the bulls.
Art was absolutely right about the Fed’s announcement but the market didn’t see it as a bullish sign.

 

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The Fed Raises Rates, the Market Throws a Party

Back in September we wrote two short articles on the long anticipated rate hikes.  Dear Fed: Just Do It! Followed by Oh No They Didn’t!

Our thesis was that the Fed’s zero interest rate policy  (ZIRP) wasn’t doing anything for the economy and that a rate hike would actually be viewed as a vote of confidence in the current slow growth economy.

Main Street may not be enjoying a boom, but Wall Street is doing just fine. Thanks to corporate actions to improve profitability, the continued emergence of new products and technology, and a drop in oil prices caused by huge supplies of new energy, companies are reporting record earnings.

Yes, there are pockets of weakness caused in part by an inevitable slowdown in Chinese growth and its insatiable appetite for raw materials, but here in the U.S. the low interest rates are hurting savers more than they’re helping the economy.

Today the Fed announced a much anticipated 0.25% hike in rates.  Despite predictions in some corners of a market sell-off, the DJIA rose by 1.28%, the S&P 500 rose by 1.45% and the NASDAQ by 1.52%.

Thank you Fed.  It’s long overdue.

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Would You Make a 0% Interest Loan?

Did you know that the U.S. Treasury has sold $1 trillion (yes, trillion with a T) dollars worth of Treasury bills that pay no interest? Why would anyone lend out his or her money without charging interest? One answer might be because the alternatives seem worse. In fact, for a brief moment in 2008 investors were willing to earn negative interest and actually pay for a U.S. Government guarantee to get back less than they put in!

To understand the alternatives you have to realize that the people who do this are not mom and pop investors. They are the huge players who round to the nearest million and deal in billions of dollars. They don’t have the option of putting their money under the mattress.

These people don’t deal in physical dollars, so when they raise cash it has to go somewhere else. Not doing something with their money is not an option. When both stocks and bonds are going down, the only relatively safe haven is the U.S. Treasury market, and the safest part of that market is short-term Treasury notes. When there is not a big enough supply of notes but you need to buy anyway, you accept a negative interest rate.

Of course, individual investors have been willing to leave their “safe” money in money market accounts paying virtually zero percent for several years now. That’s a rational decision since literally putting your money under your mattress or burying it in the back yard leaves you vulnerable to thieves and robbers. But it may make the smaller investor feel better that the “big boys” with their billions are sometimes worse off than the retail investor when it comes to finding a safe haven.

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Oh No They Didn’t!

The big financial news of the moment is that the Fed decided not to raise interest rates, though 13 of 17 Federal Reserve officials say that they see a rate hike by the end of the year.  In their statement, they cited “recent global economic and financial developments” as their reason not to raise rates today.  However, Chairwoman Janet Yellen cautioned that people should not “overplay the implications of these recent developments,” saying that they “have not fundamentally altered” the Fed’s outlook on the economy.  All of this leads us to believe that we are likely to see a similar media build-up around the Federal Open Market Committee’s (FOMC) December 15-16 meeting.  (There is another FOMC meeting scheduled for October 27-28, but at this point, there is no press briefing currently scheduled for that meeting.)

Whenever the Fed finally does raise rates, expect it to be a very SLOW process.  Ms. Yellen alluded to as much when she said, “the stance of monetary policy will likely remain highly accommodative for quite some time after the initial increase in the federal funds rate.”  Charles Schwab’s Liz Ann Sonders provided the following chart, which bodes well for the stock markets (unless we are all wrong and the Fed suddenly starts hiking rates quickly):

Interest Rates

As we wrote just the other day, we expect the Fed to increase rates and would have preferred to see them do it sooner rather than later.  The rate increase is widely expected to be in 0.25% increments, which should not have any significant effects on the economy.

Following the Fed’s stand-pat announcement, the stock market actually declined slightly (and futures are down as we write this morning), indicating that their position is being interpreted as an indication that the Fed does not have total confidence in the strength of the economy.

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