Why the Fed Will Cause Interest Rates to Fall
Few people understand what drives the value of interest rates, yet most believe that interest rates are going to continue rising. Last Friday, Dr. Lacy Hunt of Hoisington Investment Management Company spoke at the annual Strategic Investment Conference in San Diego. This conference is attended by some of the most elite money managers from all around the globe where they discuss the hot topics surrounding today’s investment climate. With interest rates being a hot topic, Dr. Hunt, who in my opinion is the foremost expert on bond yields, inflation, the money supply and the Velocity of Money, was invited to be the final speaker of the conference.
Dr. Hunt’s views on interest rates, which he backed with data and algebraic explanations, were in opposition to nearly every other speaker. Over the next several weeks or more, I plan to share with you what I learned from the various speakers at the conference. While I can’t share with you their charts or presentations, I will attempt to share with you their views and my thoughts on them.
The Law of Diminishing Returns states that increasing a factor of production will lead to increased output. It also states that as a single factor of production is increased, the returns will decline or diminish. Our government has been using deficit spending to create growth for decades but as our debt levels rise, the amount of GDP (Growth Domestic Product) growth generated from that debt is declining.
In 2002 total global debt as a percentage of global GDP was 246%. At a debt to GDP ratio of 246%, every new dollar of debt issued generates 41 cents of growth. Today global debt as a percentage of global GDP is 327% and as a result, every new dollar of debt generates 31 cents of growth. From an investment perspective, the return on investment of adding more debt is poor. None of us would willingly make that exchange, yet central banks believe that our growth problem can be solved by borrowing more money. This means that more debt will lead to less growth, which includes any debt issued regardless if it is to finance tax cuts, infrastructure spending, or any other means to stimulate economic growth.
While global debts continue to rise, the Federal Reserve has decided that this is an appropriate time to begin selling off its $4+ trillion in U.S. Treasury and Mortgage-Backed Securities debt and to raise the Federal Funds rate. The effect of both actions is the tightening, or reduction, in the money supply of our country and the reduction in bank credit. Dr. Hunt shared that each quarter percent increase in the Federal Funds rate has the equivalent effect of removing $60 billion from the money supply. The Fed has already sold $70 billion of bonds from its portfolio, which has the effect of increasing the Federal Funds rate by 0.25%. In other words, the Fed’s balance sheet unwind is having the same economic impact as if the Federal Funds rate was 1.75% instead of its current rate of 1.5%.
To put this in perspective, experts believe the Fed will raise the Federal Funds rate four more times this year by a total of 1%. The Fed also plans to sell off about $230 billion of bonds by the end of 2018, meaning the effective Federal Funds rate by the end of the year should be 3.75%. To you and me, that means short-term interest rates should continue to rise.
Every week I cover the growth rate of the M2 Money Supply, which has been decelerating for the past year. Dr. Hunt showed that 17 out of the last 21 recessions since 1900 occurred during a deceleration of the M2 Money Supply. Normally deceleration in the money supply is deflationary, but last quarter the economy, interest rates and inflation increased.
Dr. Hunt explained that the boost in economic growth last quarter was due to the two hurricanes that caused the Velocity of Money to increase. The Velocity of Money is simply the number of times money exchanges hands in a year. The more often money changes hands, the more inflationary it becomes. Last quarter there was a slight increase in the Velocity of Money, which Dr. Hunt believes is transitory. He said the reason the Velocity of Money increased was due to the insurance claims paid on all the damaged property. For those who have been involved in an insurance claim, we know that premiums rise following the payout on a claim. As money flows back to insurance companies, that means there will be fewer dollars available to be spent in the economy.
The evidence that insurance claims were a cause of the increase in the Velocity of Money is found in the automotive sales data. Following the hurricanes, automotive sales increased sharply, indicating that damaged vehicles were being replaced. Dr. Hunt showed that fourth-quarter GDP would have been 1.8% if automobile output was excluded instead of the 2.5% growth rate that was posted. With automobile sales falling in the past two months, there is validity to Dr. Hunt’s claim.
He went on to say that bank credit is falling faster than the fall in the M2 Money Supply, which means that the Velocity of Money will also fall. A drop in bank credit and a drop in the M2 Money Supply has caused recessions in the past.
It is important to understand that short-term interest rates are not correlated with long-term interest rates. When the Fed raises short-term interest rates it reduces excess bank reserves, which leads to a drop in demand. Long-term interest rates are a function of the Fisher Equation that states that Treasury bond yields are a function of the sum of the real rate and inflationary expectations. Milton Friedman, an American economist, surmised that a deceleration in the monetary base (or decline in the growth rate of the M2 Money Supply) leads to lower bond yields.
According to Dr. Hunt, sustained tightening of the monetary base will lead to lower inflation and lower bond yields. Tightening may lead to a temporary rise in yields, wages and prices, but ultimately these increases will be rejected because there isn’t enough money to sustain these increases. This happens because an increase in consumer prices that isn’t backed by an increase in the money supply to afford them will cause consumers to reject higher prices.
The remainder of Dr. Hunt’s presentation focused on Quantitive Tightening, or the unwinding of the Fed’s $4+ trillion balance sheet, and the recent tax cuts. His research indicates that reducing the Fed’s balance sheet should lead to a reduction in the M2 Money Supply, the money multiplier and the Velocity of Money. When all three are falling, GDP growth, consumer prices, and wages should also fall. In the short-term, wage increases will affect corporate profits as demand falls, but over the long-term, wages will fall as layoffs increase. While most experts believe tax cuts are stimulative, because they are being financed by increased deficits, the tax cuts will actually cause the Velocity of Money to further fall.
During the question and answer section, Dr. Hunt was asked if his view had changed since the February nonfarm payrolls report showed that over 300k jobs were created. He quickly pointed out that payroll reports are a lagging indicator that is typically 2-3 months behind. He reasoned that employers decide to hire several months before an employee is actually hired. In Dr. Hunt’s view, the payroll numbers we saw reflected the mood of employers back in the fourth quarter when the economy was responding to the two hurricanes. This is why Dr. Hunt doesn’t focus on any single payroll report, but the year-over-year rate of change, which he said is very low and likely to continue falling.
To summarize, Dr. Hunt believes that long-term interest rates will fall and likely set a new all-time low during the next recession which, he believes, is coming within the next 12-24 months. If his research is accurate, and I believe it is, bond yields will fall to new all-time lows and bond prices will rise to new all-time highs. Furthermore, as the economy slows, asset prices will fall. If that is the case, then those holding cash in their portfolios will find opportunities as other race to get out of the stock market before their retirement savings are decimated in the ensuing recession.
Q&A with Steve – Your Questions Answered
- How did the big bond auctions go?
Both the ten year and the thirty year bond auctions were strong, indicating that investors are demanding longer duration bonds over shorter duration bonds. As you may have guessed, Wall Street was surprised at the strength of the auction. As I expected, in the days following the auctions, Treasury yields have fallen.
- Any updates on the new Momentum Strategy?
Several – I’ve been working on a master tab on the spreadsheet that will pull all the data from the other sheets so I can view all of the opportunties on one tab. This will allow me to identify opportunties and set the portfolio weightings in one place. While this may sound simple, it involves more complex formulas to dynamically pull data based on a specific row across 50 different tabs.
I haven’t put all of the funds into the sheet yet, but I will eventually.
There are still some discrepencies with a couple pages, so I need to get everything unified.
It has identified potential opportunities across several bond funds, the utilities sector, the real estate sector, the telecommuncations sector, gold miners and silver miners. Nothing has flagged a buy yet, but I expect within the next week or two that it will. Once it does I will start adding positions to the portfolio based its recommendations.
And I still need to write some more formulas for the buys and sells. Quite a bit left to do, but I have it working well enough to identify opportunities.
Video Topic of the Week – Lagging Indicators
The stock market is behaving as a lagging indicator. This week I take a look at Dr. Hunt’s view that the recent surge in the employment data is going to fade.
Chart of the Week – More Momentum Charts
This week I wanted to walk through a few of the opportunities that the momentum screen is identified as strong candidates for investment. We’ll go through a few price and momentum charts so you can see what I’m seeing as potential sectors to invest in.
Portfolio Shield™ Update –
The March 2018 Investment Detail Report is now available.