In our 1/2/18 post “2018” we suggested that the only group that could supply new funds to push the stock market higher was the public at large. The figures for December and January are in they show this group’s participation was the greatest since the “Great Recession.” They bought pushing the market to the stratosphere. Unfortunately, with no more new money available, the market was set up for a change of direction. The reason given for the subsequent sharp down move was rising interest rates. The bulls argue the market hadn’t had a correction for an abnormally long time and was overdue. In any case interest rates are historically low. Even the recent rise and the projected Federal Reserve moves should be easily handled by worldwide growth. After all, economic expansions in the past faced much higher rates and still thrived. In the US profits will be greatly enhanced by the recent tax revisions. Wages and optimism are rising. Solid reasons for expecting the economic expansion to continue accompanied by rising profits. This should be reflected in higher stock prices.
On the surface this makes a lot of sense but what if the recent interest rate rise even from such low levels is indicative of a much more dangerous situation? In our series the Long Journey to “More” the post Free Capital to Finance “More” attempted to show how the world’s central banks led by our Federal Reserve had caused massive distortions to the traditional risk pyramid. Instead of a base of relatively safe assets tapering up to high risk, we had a pyramid of mostly risky assets. With so much risk already, investors might really be reluctant to go after the really high risk/high reward ventures. We thought this might help explain the tepid growth throughout the era worldwide “Quantitative Easing.” The theory behind the central bankers move to zero or negative interest rates was to drive up the value of risk assets giving their owners gains resulting in a “wealth effect.” This would result rise in greater consumption driving growth. Some economists claim this indeed added to growing GDPs. The consensus in the US is that it added about 1/2% to our GDP. Even granting this might be true, it has left investors far and wide with horribly unbalanced portfolios. Across the board they’re out of line with normal risk tolerance.
Even a base of government bonds are riskier than in the past. Because of their meager returns, many investors can’t meet their obligations (or as we say pay our bills) solely on their income. After all the whole point of the Central banker’s actions was to make quality fixed income investments a bad deal. Now with rates going up we’re going to find out just how bad. In free markets the law of supply and demand rules. What we can see is enormous needs for credit and little incentive to supply it. The growing world economy is faced with increasing consumer credit demands, businesses needing credit to expand and governments running deficits that need to be financed. In the US, the recent budget agreement will give us trillion dollars deficits as far as the eye can see. Add to this, the national debt is understated by limiting it to debt held by the public. Internal debt such as Social Security is excluded. As a “pay as you go” plan it was never expected to have to be repaid. As Social Security now faces deficits this too will have to be financed or benefits will have to be cut. Does anyone really think that will happen? Largely overlooked is the declining payments the Federal Reserve is sending to the Treasury. In 2017 this amounted to $80.2 billion down from $97.7 billion in 2016. This is projected to continue to decline as the Fed winds down its $4+ billion holdings it acquired during “Quantitative Easing” battle to bring interest rates down to the zero area. Of course, until these holdings are sold they constitute a further massive overhanging supply of bonds for the market to digest.
So there you have it, a huge visible demand for funds. Who is going to supply the money? Other than those institutionally required to buy quality debt, no one with discretion and a sound mind should commit funds at today’s rates. Already those who bought the US 10 yr or 30 yr Bonds in the last three years under water. Most of 10 yr bonds were bought at yields under 2 1/2% and the 30 yr under 3%. If we just move to the still historically low rates of 4-5%. the losses will be enormous. A US 3% 30 yr $1000 bond bought a year ago would be worth less than $700 in a 5% world. Because of the race for returns, the yield spreads for lesser bonds, investment grade to junk over US government bonds narrowed, now with rates reversing they’ present even greater risk. Last week saw expanding spreads. If bonds begin to give much better returns how will high-priced stocks fare? If they fall, will it bring a reverse wealth effect?
Even the expectation the Federal Reserve will have 3 quarter point interest rate hikes in 2018 would be painful, but how much control does the Fed actually have? It historically set short-term rates. To keep longer term rates from rising sharply, it would have to add rather than reduce its already enormous longer term holdings. The fact that these would be paid for by creating money by bookkeeping entry in already strong world economy could perceived as highly inflationary. Bond buyers would then add to the inflation premium they’ll demand pushing rates even higher. Already higher wages in the latest quarter have brought inflation fears to the forefront. Don’t look for foreigners to bail us out. Euro zone Treasury bond buyers suffered a 8+% exchange rate loss due to the dollar’s fall in the last year on top of the rate loss. Adding to the problems is the circular effect of rising rates. They add to the cost of servicing our national debt. Even before the recent tax cut and budget bill, servicing the debt was projected to increase from about $300 billion today to over $800 billion a year in the next 10 years.
Thanks to the Central Bankers, all this hitting when investors portfolios are as unbalanced as never before. When you lose your balance you’re far more susceptible to a bad fall. For all these reasons, the heretofore least favored asset class, cash, may suddenly be in demand as people forget about returns in order to preserve principle. Raising cash means selling not buying, but if you can acquire anything at a better price and value in the future by biding your time, you wait. This by itself may cause a buyer’s strike and a spike in interest rates. After all, markets exist to discount the future. When smart people, in this case Central Bankers, put their ideas above the collective wisdom of the market the results historically haven’t been great. A sudden unexpected economic downturn occurring now with already low rates and swollen Central Bank balance sheets, what could these Central Bankers do and to what purpose?