Market Newsletter - Q1 2016
Monday, February 22, 2016
As we expected, the Federal Reserve raised the Fed Funds Target Rate 25 basis points (0.25%) to 0.50% at its December FOMC (Federal Open Market Committee) meeting and additionally gave guidance that it expected to raise the rate 3 or 4 times in 2016 to approximately 1.375% by year end. Not only do we think that the December increase was premature, we think that the 2016 time table is overly aggressive and probably won’t come to pass. Furthermore, beyond 2016 we expect a long slow slog in the Fed’s efforts to “normalize” rates.
The “strength” in the economy that the Fed cited as justification for its December hike has proved elusive. We thought the case was overstated then and more recent figures (and the markets’ reactions to them) have confirmed this. Also, tightening here was “against the grain” as both Europe and Japan were easing. This has only exacerbated the strength of the dollar, which is at decadal highs and according to The Economist’s “Big Mac Index” is exceeded globally by only the Swiss Franc. This is clearly hurting American competiveness abroad. Apple reported that the strong dollar cost the firm $5 billion in lost revenues in the fourth quarter of last year alone! This part of the story has been well-chronicled in the financial press, but there are two additional barriers in the path to higher rates that have largely been ignored, a “liability” trap and an “asset” trap.
Consider the $14 trillion of public U.S. Government debt outstanding. The bonds funding this have an average maturity of about 6 years. Trillions more of state and local debt are piled on top of this. A rise of a couple of percent will be a budget-busting nightmare in terms of debt-service costs. For example, even in today’s low-rate environment such costs amount to 10% of the state budget here in Connecticut. Chicago and other cities with junk bond ratings will be pushed to the brink quickly by even modest increases in borrowing costs.
There is another side to this coin as well. Over the past few years the Government has issued hundreds of billions worth of longer-term bonds. These bonds are held by pension funds, banks, insurers and others. “Normal” rates will inflict huge losses on these portfolios. Consider the 2.5% coupon 30-year U.S. Treasury issued in April 2015. When 30-year rates went to 3.3% in June, this bond fell to 88. If in two years 30-year yields are 5%, this bond will trade like a junk bond at 63. Currently underfunded pension plans holding such bonds will fall further behind and the credit ratings of insurance companies could be threatened.
These problems become more intractable as time goes on, governments (at all levels) financing and refinancing themselves with low-interest debt and the subsequent securities becoming an ever larger share of debt portfolios. The Fed, along with central banks in Europe and Japan, has fenced itself in and constrained its ability to raise rates without inflicting significant damage on the economy. A burst of inflation, dictating that they need to raise rates, would be a major dilemma. These factors, combined with the continued slow rate of the recovery, suggest that rates will remain below historical norms for quite some time – years, if not decades.