Focus on Fed Policy
Recently all eyes have been on Fed policy regarding the possible tapering of bond purchases. This preoccupation with Fed policy has led investors to liquidate bond mutual funds and ETF’s in record amounts. This has led to a rapid rise in interest rates to the highest levels of the last two years. Mortgage rates have soared to 4.5% during the last six weeks. The chart below shows the rise in 30 year mortgage rates since the Fed announced it might start tapering bond purchases. We feel investors are currently focused on the wrong thing, and the rise in rates has created a buying opportunity in bonds.
What Drives Interest Rates
The two primary drivers of interest rates are the general level of economic growth, and inflationary expectations. Fed policy is largely driven by these conditions and is very much “data dependent”. The economy only grew at a 1.8% rate during the 1st Quarter of this year. This is significantly below the long term economic growth trend. The Fed has had a history of being overly optimistic about future growth in the economy. Forecasts of higher growth rates for the rest of the year strike us as being overly optimistic, considering the recent move higher in interest rates. We expect higher rates to slow down the housing market and the economy in general during the rest of the year. It is important to remember that stronger economic conditions for the rest of the year is not a known event. We feel a continued period of weak growth is more likely. Higher tax rates, higher mortgage rates, a slowdown in government expenditures, and negative demographics are all headwinds for the economy. The debt limit ceiling will need to be raised by early fall to keep the government running. There has been no talk of progress made in Congress regarding the two parties working together to address the budgetary issues facing the country. Instead, both parties are becoming even more polarized. It is hard to imagine this changing soon. The potential for negative noise coming out of Washington concerning budget battles and the debt ceiling may also be a drag on the economy.
The chart below shows the continued decline in inflationary expectations. This trend is not indicative of rising rates. In fact, it seems to be providing a green light for the bond market. Many investors believe the expansion in the Fed’s balance sheet has to be inflationary at some point. However, the data does not support this argument at this time.
The Fed’s QE Experiment
The Fed began Quantitative Easing (QE) during the financial crisis in 2008. Quantitative Easing occurs when the Fed expands it’s balance sheet by purchasing assets such as U.S. Treasuries and Mortgage Backed Securities. QE is supposed to be a monetary tool which is used when the Fed Funds rate is at or near zero and unemployment is high and the Fed believes more monetary easing is necessary. QE is a tool to lower long term interest rates to stimulate economic growth.
The chart above shows the last two rounds of QE have not been as effective in lowering interest rates as QE1 and QE2. The diminishing returns of QE3 and QE4 cast a shadow of doubt concerning the effectiveness of continued QE. Quantitative Easing has been tried in Japan with little success as the Japanese have been engaged in a 20 year battle against deflation.
Stuck In A Liquidity Trap
The velocity of money, as shown in the chart below, has continued its downward trend. This is a sign we are in a classic liquidity trap, and monetary tools are relatively ineffective in stimulating the economy.
This has occurred because there is too much debt in our system, and demographic trends are very negative for the economy. The Fed’s monetary tools are designed to encourage borrowing to stimulate economic activity. This does not work well in a highly indebted economy. The large number of baby boomers and longer life expectancies have created a large group of older people in the U.S. An aging population does not have enough consumers in the accumulation phase of life. They are not borrowers and spenders. Instead, there are more consumers who are spending less on things, and more on healthcare. This is very negative for economic growth because it dampens the effectiveness of monetary policy.
How High Should Rates Be Without Government Manipulation?
The question fixed income investors should be asking is “how high should rates be without the government trying to manipulate the market?” We believe the current level of rates offers value to investors. Inflation is running at about 1%. The Fed has made every effort to get it higher without success. Japan has been in a similar situation. The 10 year JGB still yields less than 1% in Japan. Our 10 year UST yields about 2.55%. The German bund yields 1.58%, the rate in the UK is 2.34%, and is only 2.2% in France. Corporate and Muni yields are higher still. Long Munis for good BBB rated bonds yield over 5%. This equates to taxable equivalent yields of 8-10%. These are very attractive rates for retail investors.
Conclusion
Investors should pay attention to the weak trend of economic growth and low inflationary expectations. The recent selling of bond funds has created a good opportunity for investors to add to their fixed income positions at prices which have not been available for the last 2 years.
