June 10, 2009

 

WHY THE LATEST

MOVE IN INTEREST RATES?

A Special Commentary by

Brian Turner, Director – Southwest Corporate Investment Services’ Advisory Services

 

 

Wondering what might be driving the recent uptick in short-term treasury rates and the steepening of the curve since the end of 2008? Many believe it to be a cause-effect of the latest employment report showing less job loss than in previous periods - as if you can call another 345k decline in non-farm payrolls a definitive sign of recovery. A more interesting, and possibly more reasonable conclusion might be that bond traders are finally beginning to anticipate a much greater upward inflationary environment than the Federal Reserve lets on and is starting to take matters into their own hands.

 

The conclusion would not be unprecedented. During the late 1970s, under then Fed Chairman G. William Miller, core consumer inflation had approached 12 percent to the ire of bond traders.  After Paul Volcker took the helm in 1979 and under a new administration with strict monetarist beliefs and intervention, inflation eventually dropped to 3.5 percent. Soon thereafter, however, early warnings of upward inflation began to re-emerge. Fearing that the Fed again might not do enough to tame it, like under Chairman Miller, bond traders literally took matters into their own hands driving the ten-year Treasury note rate up from 10 percent to 14 percent in less than one year. The resulting inflation rate was capped a little below 5 percent.

 

Fast forward to 2009. Let's start with fiscal monetary policy and inflation:

 

More than three months ago, the Federal Reserve announced its $1.3-trillion plan that was specifically targeted to drive mortgage rates down and help to stabilize the collapsing housing sector. Follow that with the additional federal government intervention into the banking, auto industry, transportation and now healthcare sectors,   and the level of public infusion of dollars is projected to more than quadruple the nation's debt burden in less than ten years. Already, the public debt has grown from 37 percent of GDP in 2007 to approximately 83 percent. The current 2010 budget projects that ratio to increase to 97 percent by the end of 2010 - a record $1.8-trillion budget deficit for the year. This points directly to greater inflationary pressure, both short- and long-term, and higher interest rates.

 

The core inflation rate is reported to be around 1.7 percent on an annualized basis. But since the Federal Reserves' initial announcement, and after seeing some signs that the downward economic trend had improved, the benchmark ten-year treasury note rate has risen from 2.54 percent in March to 3.88 percent  - 134 basis points , much higher and faster than what any associated economic improvement might translate into higher inflation. During that same period, the average thirty-year fixed mortgage rate has increased from 4.85 percent to 5.59 percent, the highest since last December, according to the latest information from Freddie Mac. In terms of the consumer market, rates have also increased and more recently, the benchmark two-year treasury note rate has risen from 0.81 percent to 1.38 percent - 57 basis points (38 bps since the unemployment report alone).

 

Could it be that bond investors are growing more fearful that the trillions of dollars the federal government will need to fund all these stimulus programs and the growing debt burden associated with it will eventually lead to accelerated inflation - more than any associated upturn in economic growth would create? As in the early 1980s, bond traders could be intervening directly by moving term rates higher now before the effects from current policy and projected spending take hold, thus potentially avoiding another 1970s-like disaster. Whether this will send term rates as much as 400 basis points higher, as in the early 1980s, is questionable albeit 100 to 300 bps is reasonable.

 

Like holding a lid down on a pressure cooker, the Fed is currently trying to keep interest rates down to fund all the spending programs they are planning. Whether they are cognizant of the long-term economic damage it might be imposing is in question. One action that they took more recently was the $1 trillion in mortgage-backed securities they bought from the market to help drive down fixed mortgage rates to their lowest level since 1971. This certainly helped to stop much of the bleeding by returning some level of confidence to the financial market and created refinancing opportunities to mortgage borrowers - but at what cost (how much pent up pressure is under that cooker's lid?).  But, with the recent upturn in term rates, both bond and mortgage, short-term stimulus opportunities might be already wavering. Some project that 70 percent of refinancing activities could be eliminated the closer 30-year mortgage rates climb to 5.5 percent. Even now, many lenders believe that about 50 percent of the contracts in the current pipeline are already dead.

 

This morning's WSJ has an excellent opinion piece by Arthur Laffer. He notes that the percentage increase in the monetary base will be the largest increase in 50 years by a factor of 10. According to Laffer, banks have been making new loans and increasing liabilities. In fact, the twelve-month growth rate of M1 is now more than 15 percent, close to its highest level in the past half century. Yet this, in essence, could eventually reduce the demand for money. A lower demand for money and a rapid growth in the money supply is a surefire recipe for inflation and higher interest rates.  According to Laffer, certainly what has happened so far this year has potentially far more inflationary impact than the monetary policies of the 1970s - to which I agree.

 

Two things remain to be seen- 1) If stimulus does lead to growth, how long-term will it remain (remember the tax rebates last year - one quarter) and 2) If growth is extended but inflation in fact re-enters the equation (as is reasonable to expect), to what level might it drive up interest rates and for how long? Currently, there are no definitive signs that indicate that any subsequent increase might be any higher than what a traditional cyclical trend of 100 to 200 bps would attest because the actual federal spending hasn't begun in earnest. However, a more credible factor could at what accelerated pace the  pending rise in interest rates will take - in other words, moving upward to that particular rate level in a shorter period of time. Again, there are too many unknown variables, seen and unforeseen, to form a definitive position today.   Of course, if the stimulus doesn't advance growth, we'll have a yield curve so steep that even Tony Hawk couldn't maneuver it.

 

If you are of a monetarist persuasion, the only way to stave off this upward inflationary pressure higher interest rates is to contract the monetary supply.  This would be difficult in that for every $1 trillion it would need to drop the money supply,  the Fed would have to sell $1 trillion in bonds and, as Laffer points out, would be in direct conflict with Treasury's planned issuance of $2 trillion in bonds over the next 12 months. Reducing the money supply unfortunately would also contract lending, as was the case in 2000 and 2001, the last time the Fed intervened as such, sending the economy into a recession.  

 

So in that case, any acceleration in interest rates, regardless of where the eventual rate level might peak, could occur sharply and quickly over  the next one or two years. After that period of time, the massive federal government debt burden would continue to have severe implications on the economy, strangling growth and threatening another and possibly deeper recession. Paraphrasing Laffer - the short-term pain of a deepened recession (now) might be preferable to the long-term consequence of double-digit inflation.  My hope is that the bond traders again have it right. 

 

A diving roller coaster is defined as a ride that, after experiencing a double-down drop (a drop that is immediately followed by a second drop that passengers are unable to anticipate) subsequently begins to climb another life hill, momentarily hangs precariously at the top and then dives 90 degrees. So if you feel like you're just beginning to catch your breath after coming out of a double-drop down loop-to-loop, we're not getting off just yet. The life hill approaches.

 

 

 

Brian Turner

Director, Advisory Services

800.442.6427 | 214.703.7881