Interest Rates and National Debt

Interest Rates and National Debt

Interest-Rates-and-National-DebtThe Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month I discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013” published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon.

The current 10 year Treasury interest rate is about 1.8%. It reached its lowest level in July 2012 at 1.53% and the highest rate was 15.32% in September 1981 when Paul Volker put the kibosh on inflation. The historical average rate has been about 4.6%. The current annual interest payment on the debt is just over $220 billion. If interest rates were to rise to only the historical average of 4.6%, that would be an increase of 2.8%, which would be an increase of nearly $110 billion, if we assume for simplicity that all the new issuance is a 10 year terms. (The reality is that some would be shorter term, some would be longer, and this is just meant to give an approximation to illustrate the magnitude of the impact.) That means interest expense on the debt would increase a whopping 50% in the next year. If the deficit spending continued at about the same rate for the next 6 years, annual debt interest payments would become the government’s costliest expense by 2020. For every year that we continue to deficit spend, increasing the national debt, the magnitude of the impact of rising interest rates increases.

That puts the Federal Reserve into quite a pickle if the economy does in fact gets some legs and inflation ignites. Don’t raise rates and face punishing inflation. Raise rates and D.C. is going to be put under even more pressure to reduce spending. No wonder Chairman Ben Bernanke has been giving subtle indications that he isn’t keen on yet another term as Chairman!

Monaco Conference: Saving the World Financial Systems

On April 25th I spoke on a round table at the XIth International CIFA FORUM in Monaco on Saving the World Financial Systems with Luca Fantacci and my good friend Dan Mitchell.   Click here for a video clip of an interview after my talk.  Below that are my thoughts from the discussion.

If you incorrectly identify the fundamental cause of a problem, you will most certainly prescribe an inappropriate solution.  The cause of the crisis was government policy, both monetary and fiscal.  How likely is it that those in power will identify the causes as their own actions and suggest appropriate cures?

For those that say the cause of the crisis was purely financial innovation; all human progress is by definition base on innovation because anything that is better is different.  Clearly not all innovation is better, but all innovation is different from what existed before.  To squash innovation is to end human progress.

The Federal Reserve, and an increasing number of Central Banks around the world, seem to believe that their role is to prevent market corrections, to ensure the “Great Moderation.”  Every time the housing market attempted a correction, (before the Great Recession), which is a natural and healthy process in the free markets, various government agencies took some action to support the market.

The Fed often over-expands the money supply to eliminate natural market corrections. This effectively provides a major incentive for banks to take on more risk.  Thus the Fed reduces short-term liquidity risk at the expense of increasing credit risk.

This only increased the magnitude of the inevitable correction as for many in the housing industry, the knowledge that government policy makers could and would act in an aggressive manner to save the housing market made them significantly less willing to act to reduce risk than they would have otherwise had the market been a free market.  Look at the stock market today and the level of inappropriate risk taking based on financial repression and the belief in Central Bank “puts.”  By 2007 most of the CEOs of major banks had not been through a major correction thanks to this repetitive put, thus didn’t know just how bad things could get so where ill prepared to handle the crisis, which only served to exacerbate it.

  1. Fed monetary policy created a rapid appreciation in residential real estate values with obscured the risk in lending in this sector.
  2. Residential builders and developers did not have easy access to capital markets and were willing to pay variable interest rates when Bernanke inverted the yield curve.
  3. Heavy regulatory burden including (Privacy Act, Patriot Act, SOX) make banks not be cost competitive with the “shadow” banking system.
  4. The capital standards created by the regulators, under Basel, created strong incentives for banks to hold home mortgages to meet capital requirements. — In a truly private banking system, some banks would have still done this, but it is highly unlikely that the vast majority of bans would all be making the same mistake.

One of the primary ways a Central bank controls the monetary supply is through the banking system, by encouraging banks to lend more money.  One way that Central Banks can affect this is to allow the largest banks to increase their leverage.  Smaller banks will eventually have to follow; if they do not, they will end up with a lower ROE than their larger competitors, making themselves vulnerable to being acquired.  This would allow the larger acquiring bank to leverage the “excess” equity of the smaller bank.

In early 2006 Bernanke rapidly increased interest rates and created an inverted yield curve.  He held this for more than a year, from July 2006 to January 2008, (one of the longest yield curve inversions in history).  Banks have to engage in economic forecasting to manager their interest rate risk.  That was no evidence that would have led bankers to anticipate a 425% increase in interest rates in 2 years.  The unanticipated pace and magnitude of rising interest rates left banks with negative margins.  Of course Bernanke and Greenspan insist there were no errs in policy during the 2000s – a dangers sign that the current Chairman cannot admit to any mistakes.

We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.

KEY ECONOMIC METRICS

Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.

The Markets Love Bernanke?

The other day while I was organizing my office for the umpteenth time, (how is it that someone as obsessively organized as I am consistently has a messy desk?) I heard a reporter on the television say, “The markets love Bernanke.” I immediately glowered at the screen. After a few annoyed minutes and some distracted paper cuts, I realized, she’s right. Clearly if talk of him not getting reappointed causes the markets to drop, they must have some affection for the man. But how can this be? I come from the school of thought that increasing the bank reserves from $10 billion to $980 billion in a few months is not the best solution for an economy in turmoil and of course believe that any rational human being would agree with me, (note wry grin) so why do the markets seem to love him?

Then it dawned on me as I cleared away the seriously overused coffee mugs that hold my precious nectar of the Gods every morning. The markets love liquidity, thus Ben Bernanke. It is a bit like the love an addict has for their dealer, or me for my espresso machine. I highly recommend the Jura Capresso for those suffering from the same affliction. The recent talk that he might not get confirmed briefly sent the markets into a tizzy as their liquidity dealer might get kicked out of the neighborhood.

So why does an increase in liquidity cause asset prices to rise? You can think of it like a seesaw, with the price of money on one end and the price of assets on the other. As the price of money (interest rates) goes down, the price of assets goes up. If Bernanke is replaced with someone who is less likely to keep their side of the seesaw down, asset prices will drop.