Weekly Economic Update 03-09-2018

Going Once, Going Twice…

Next Monday investors worldwide will be focused on the outcome of the planned 3-year, 10-year, and 30-year U.S. Treasury bond auctions. It will be one of the largest long-term bond auctions in the history of this country. Speculators have been heavily shorting U.S. Treasury bonds for the past month as they hope for a failed auction that would send bond yields higher. Commercial hedgers, who are buyers of U.S. Treasuries, have been buying Treasuries in hopes of keeping interest rates from spiraling out of control. While the victor of this battle is unknown, what we do know is that few people truly understand the dynamics of what causes bond yields to rise and fall.

Prior to the early 1980’s, the Federal Reserve could control both short and long-term bond yields by raising and lowering the Federal Funds rate. The Federal Funds rate is the bank overnight lending rate that banks must pay if they need to borrow money from another bank to meet the Fed’s overnight reserve requirements. As President Reagan increased our national debt by 1.86 trillion, the Fed’s ability to control long-term interest rates vanished. Our government was borrowing so much money relative to the economy that they began crowding out private investments, which caused long-term bond yields to fall. It would take the Fed twenty years to realize that they could only affect short-term interest rates.

By raising and lowering the Federal Funds rate, the Fed can increase or decrease short-term interest rates. When our economy starts heating up, the consumer allows their cash reserves, typically held within the banks, to fall in hopes of taking advantage of a higher potential return on investment by deploying their savings into the real economy. As cash levels at banks fall, the banks then find themselves needing to borrow more frequently to maintain their overnight reserve requirements. To pull capital out of the economy and into the banks, the Fed increases the Federal Funds rate which causes other short-term rates to rise accordingly.

As capital leaves the economy and is parked in bank deposit accounts, that money ceases to circulate which has the effect of slowing down the economy. The Fed chooses to slowly raise rates in an attempt to control the rate at which the real economy is slowing. This is why the Fed will raise or lower rates, then wait several months before deciding if it is appropriate to continue raising or lowering rates as dictated by the economy. Raising or lowering the Federal Funds rate is the Fed’s preferred method of controlling the money supply and the overall economy because the Fed can make small adjustments in the Federal Funds rate which should have equally small effects on the economy.

Long-term yields tend to have a larger impact on the economy as money is pulled out of the real economy and invested in bonds with 10 to 30 years before maturity. These long maturity bonds ensure that the money will not return to the economy for quite a long time because bond investors do not receive their principal back until the bond matures. Simply, there’s no way for that money to find its way back into the economy until the debt matures; whereas short-term debt that matures in several weeks could return to the real economy much quicker. But when it comes to the level of where long-term interest rates should be, few people understand what drives long-term yields and how our increasing government debt has an effect on yields.

One of the reasons this upcoming Treasury auction will be closely watched is because it is an indicator of how much of our debt is willing to be bought by the global economy. The more of our debt that is bought, the more money we can print without fear of causing domestic inflation. When U.S. dollars can be tied up for a decade or more, they can’t create inflation. This is simply due to the fact that the income stream or dividends on the bond are far less than the $1,000 needed to purchase a bond.

Assuming a 3% yield, a $1,000 10-year U.S. Treasury bond generates $3 in dividends per year or $30 in dividends over a 10-year period. The temporary exchange of $1,000 for $30 reduces the number of dollars in circulation, which reduces the inflationary effects from printing too much money.

The disinflationary effect of issuing large amounts of debt isn’t what causes a disruption in the economy, it’s the repositioning of U.S. dollars from the global economy into the Federal Reserve Banks that causes the disruption. When our government issues debt they receive U.S. dollars in exchange. Those dollars are pulled from the global financial system and are deposited among the 12 Federal Reserve banks for use over the next 12-24 months. When those dollars go in deposit at the Federal Reserve banks, they have the effect of lowering interest rates.

Long-term interest rates are a function of supply and demand. If there’s strong lending demand and an insufficient amount of money to lend, then interest rates will rise until supply equals demand. If there is too much supply, caused by our government borrowing a large amount of money and insufficient demand, then interest rates fall. This is why we have seen speculators attempt to drive interest rates up in the first quarter of 2016, 2017 and now 2018, as they anticipate our government issuing a large amount of new debt. Speculators incorrectly believe that when our government issues a large amount of debt that interest rates must rise significantly. Unfortunately, it doesn’t work that way.

Following the Great Financial Crisis of 2008-09, the Federal Reserve built in a safety valve to ensure that future government debt would be bought. Any unsold debt at auctions is forced upon our largest banks – they must buy our debt. While the banks may not want our debt, they have no choice but to accept it. This safety valve also prevents interest rates from spiraling out of control, because the banks are forced to buy any unsold bonds from the auction at a predetermined yield. It’s the after effect on the global economy that causes the global economy to slow and yields to fall.

When dollars are removed from circulation, even if temporarily, that leaves fewer dollars in the global economic system. Fewer dollars means the global economy must slow or adjust down to the lower level of dollars in circulation. With fewer dollars in circulation, demand falls. Since those dollars remain on deposit within the Federal Reserve system until the U.S Treasury needs them, those dollars increase the supply available to borrow against. This is why following the first quarter of each year, as our government increases its borrowing, the global economy slows, and interest rates fall. As those dollars come out of the Federal Reserve banking system to pay bills, the global economy warms back up and interest rates gradually rise.

Following President Trump’s inauguration, Congress failed to pass a budget and a funding bill for nearly a year. The delay in passing a budget kept the U.S. Treasury from raising funds, which caused the cash balance at Federal Reserve banks to fall. The lack of cash in the Federal Reserve banking system caused interest rates to temporarily rise and has given way to the belief that rising interest rates will cause high levels of inflation. Next week the U.S. Treasury will complete its funding needs which should lead to lower interest rates, a slower economy, and deflation.

The reason this is a new phenomenon is because our government’s funding needs are growing at a rapid rate – much faster than our economy is growing. The greater our government’s funding needs the more dollars that need to be pulled out of the global economy. As more dollars are pulled, it leads to stress on the global economy and reduces aggregate demand.

The timing of this massive Treasury auction is coming at a time when the global economy is cooling due to the Federal Reserve reducing the money supply. The Fed has already raised the Federal Funds rate several times and is widely expected to raise rates again later this month. The Fed is also unwinding their $4+ trillion balance sheet which is an unprecedented act by a central bank that has never been done before. The American consumer has increased their debt to levels never seen before and drained their savings, leaving little margin for error if our economic growth slows.

While the world will be watching the auction next Monday to see if interest rates are going to skyrocket higher, I will be curious to see if our economy can handle this repositioning of such a large amount of dollars. It is entirely possible that this Treasury auction could push our already fragile economy into a recession. If it does, we are well positioned to take advantage of any opportunities that will be made available to us.

Q&A with Steve – Your Questions Answered

  1. Can you explain momentum in layman’s terms?

The term momentum is often misused to define any investment that is rising. I use the term momentum to define a rate of change of the price in an investment.

Imagine you’re in your car at a stop light. The light turns green and you begin accelerating. The act of accelerating is the same as the rising price of a stock. Momentum looks at it differently. Momentum looks at the rate of change over a period of time, meaning momentum would indicate that two minutes ago your speed was zero miles per hour and now it is 15 miles per hour – a positive rate of change.

Now let’s say you reach 45 miles per hour and hold your speed. On the price chart of a stock, it would show that it’s not moving up. Momentum would show that the rate of growth is slowing, but that rate of growth is still positive.

Up ahead is a red light, so you begin to start braking. For stock investors, that would show a correction or decline in prices. Momentum would turn down and eventually show a negative growth rate as the car comes to a stop.

All momentum does is confirm the direction in price.

  1. What happens if momentum and price diverge?

Momentum is eventually always right. If price and momentum are rising, then momentum confirms the uptrend in price. If price and momentum are falling, then momentum confirms the downtrend in price. If the price is falling and momentum is rising, then the price will eventually rise. If the price is rising and momentum is falling, then the price will eventually fall.

  1. Is momentum flagging any upcoming opportunities?

My momentum research shows the sectors that are primed to rise are bonds, utilities, REITs, telecommunications and gold and silver miners.

All of these sectors are showing signs of bottoming in price.

Should we get a positive signal I will start adding small positions in these various equity sectors and then increase that position as prices rise. I foresee no plans to add to the bond position, but it is interesting that momentum is showing that a bottom is forming.

I will go through these sectors along with the price and momentum charts in more detail during the weekly video.

  1. Thoughts on the tariffs?

Tariffs are bad news for the economy. Any time trade is restricted, economic growth slows or contracts.

  1. Thoughts on the jobs report?

In the late stages of the economic cycle, it doesn’t get much better than this. Wage growth wasn’t there, but beyond that, it was good.

Expect the Fed to hike rates when they meet later this month.

  1. Why are stocks rising on low volume?

Corporate share buybacks. The data shows the retail investor was spooked by the February correction, but corporations haven’t been deterred from buying their shares back to boost executive compensation.

Video Topic of the Week – Jobs Report

Is the February jobs report a sign of strength or is it a response to the recent tax cuts?

Chart of the Week – Momentum!

A look at momentum against some of the positions we are tracking. I meant to include a few more, so hopefully I will remember to include them next week.

Portfolio Shield™ Update –

The March 2018 Investment Detail Report is now available – linked below.