One of the (many) problems with using big increases in federal government spending as an economic stimulus tool is timing. You can’t appropriate and spend it fast enough to matter much during the downturn. Spending it years later, after the economy has already begun to recover on it own, then becomes an inflation worry.
There is a new CBO study, Implementation Lags of Fiscal Policy, that details the path of the money this time around. In spite of all tyhe talk we have seen about shovel ready projects not much of the money has actually made its way into the economy yet. As you can see in the figure above, except for HHS and the Dept. of Labor, less than 2% of the money appropriated to all other departments (Education, Transportation, Energy, …) has been spent. The total spent so far is just $24.6 billion out of $379 billion.
Stimulus Spending is Too Slow-Less than 25% Will be Spent in 2009
This chart details how much of the $787 billion in stimulus money will hit the economy each year over the next three years. As you can see, only 11% of the $308 billion appropriated to discretionary spending like highways, mass transit, energy and education will be spent by the end of this year. Overall, less than a quarter of total funds will be spent in 2009.
Why is this s problem? Because there are early signs of recovery coming in now every day. By the end of this year the recovery will be undeniably underway. That means next year (2010) and the year after will be periods of rapid growth and rising inflationary worries. That’s why bond yields have increased by more than a full percentage point in recent weeks with more to come over the coming months. And that’s one of the reasons why commodity prices have been rising so fast.
Investors should be very careful to avoid long-term Treasury bonds today
JR
Note: When I wrote this explanation of budget deficits and interest rates just a year ago as a chapter of my book, Lessons from a Road Warrior, we were in a different world where budgets mattered, at least a little. We argued about deficits of $100 billion or $200 billion, and never had to use trillion in polite conversation. Today, government spending is completely out of control. Since last fall, when Congress was railroaded into giving Treasury Secretary Paulson complete discretion over spending $700 billion for the TARP bailout plan all semblance of fiscal discipline has been destroyed. Obama’s team quickly used the financial crisis to add another $1.2 trillion of spending and has added or expanded countless spending programs in his first budget. As a result the deficit for Obama’s first full budget year is likely to approach an incredible $2 trillion–not including the cost of his proposed national healthcare program. Trillions more have been provided by the Federal Reserve, without congressional approval or oversight, by taking on the authority to add all sorts of assets to their once-pristine balance sheet.
I decided to leave the numbers and the charts unchanged from the original examples in part to highlight the difference between then and now. The analysis remains unchanged. Balance sheets are still huge compared with private saving and private and government borrowing. It still takes a huge amount of government borrowing to move the needle on interest rates. And the most important question for interest rates is still whether anything is going on to change people’s willingness to hold the securities that are already outstanding, not how many new ones the Treasury is selling. But today the numbers are big enough that people all around the world are taking notice and reevaluating whether they want to hold dollar assets. This is the most important economic question of our time.
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Textbooks have it all wrong when they teach students that interest rates are determined by the supply and demand for credit. For example, a leading finance textbook (Investments, by Bodie, Kane and Marcus) states:
Forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics Nonetheless, we do have a good understanding of the fundamental factors that determine the level of interest rates.
- The supply of funds from savers, primarily households.
- The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories (real assets or capital formation).
- The government’s net supply of or demand for funds as modified by the actions of the Fed.
These statements are wrong, wrong, wrong. Had you acted on them to structure your investments over the last 30 years you would have lost all your money. Interest rates are simply a calculation we make from asset prices, as I explained in a recent post. Asset prices are determined in asset markets by existing asset supplies and the demand to hold existing assets. In spite of what the textbooks tell you, throughout history, the correlation between interest rates and deficits is actually negative; i.e., higher deficits are associated with lower interest rates. The drawings below explain why.
Interest rates are not determined by savings rates and are not determined by the demand for credit. As a logical matter, it is debt, not deficits, along with people’s demand to hold different types of assets, that determine interest rates.
Budget deficits in the ranges we have historically seen them—a few hundred billion–don’t matter much for the economy. Not for interest rates. Not for growth. The multi-trillion dollar bond markets don’t care at all whether the government is a net seller or a net buyer of $100 billion in new Treasury securities in a given year. They care whether the people who own the old paper today are still going to want to own it tomorrow. And that will depend on whether something happens to change people’s minds about future after-tax returns on bonds relative to other assets–period. The rest is all rounding errors. Nothing else matters.
People's Total Assets
When the Treasury holds an auction to finance a deficit, they print and sell new T-bills or other Treasury IOUs (notes and bonds) to investors like Aunt Tilly. This isn’t the first time the government has borrowed money from private citizens. Aunt Tilly and other investors already own a huge stock of similar old T-bills—$5.1 trillion worth at the end of 2007—that we call the national debt. At the end of last year, there were $9.2 trillion of old T-bills outstanding—the government’s accumulated borrowing since the time of George Washington. Of those, $5.1 trillion, or 55%, was held by private investors like you, Aunt Tilly and me.
New treasury paper and old treasury paper are perfect substitutes to investors. Not almost perfect substitutes—perfect substitutes. In practice, they are indistinguishable in the market. T-bills, notes and bonds are also very good substitutes for many other securities owned by investors, including agency securities, corporate securities, municipal securities and securities issued by financial institutions. These, in turn, are substitutes to some degree for equities, foreign securities and tangible assets in the minds of investors. When you buy a bond, you shop for its issuer, its maturity date, its call provisions, its tax features, and its yield—not its model year. This means that new bonds and old bonds that are the same in every other way must sell at the same price. Arbitrageurs make sure they do.
It’s like the commercial where the dad asks his teenage son to drive to the local gas station to put gas in the family car. Hours later, the dad is still standing in the driveway when his son returns with the explanation, “But Dad, you didn’t want me to mix the new gas with the old gas, did you?”
Bond investors mix the new bonds with the old bonds all the time.
Flow-of-funds is a theory to explain the price of new bonds. Portfolio balance is a theory to explain the price of old bonds. But in the real world, there can only be one price for all bonds. Which theory wins? Portfolio balance, because almost all bonds are old bonds. The important question is not whether the government will borrow money this year. It is what price it will take to make Aunt Tilly—and all the other investors who owned T-bills yesterday—still want to own the stock of T-bills tomorrow.
But balance sheets do not sit still; they grow over time. The stock of tangible assets grows as a result of building houses, factories, shopping centers and new cars faster than they wear out. The stock of private financial assets grows as people issue mortgages to finance home purchases, and companies issue new stocks and bonds to finance capital spending, home construction and durable goods production—at a faster rate than the old ones mature. We create new government securities to finance the budget deficit, or we destroy them by using a budget surplus to buy back debt.
As our net worth grows, so does our appetite to hold all assets. This growth is represented by drawing a second pie chart showing the larger stock of stuff (tangible assets) and financial assets. Historically, U.S. balance sheets have grown at about 7% per year.
Next Year's Total Asset Growth
Higher net worth gives investors like Aunt Tilly an appetite to own more T-Bills too, as illustrated in the drawing. You can think of this appetite as thousands of Aunt Tillys standing in line in front of the Treasury building, waiting to place orders for the new T-bills that the government will sell next year (to add to the ones they already own).
That appetite is larger than most people think. If net worth grows 7% next year, as it has done historically, investors will want to increase their holdings of T-bills by $357 billion, from $5.1 trillion to just under $5.5 trillion.
If the Treasury issues just enough new T-bills to satisfy Aunt Tilly’s appetite, then everyone will go away happy. There will be just enough T-bills to go around. Prices will remain the same as they were last year. Interest rates will remain unchanged.
But what would happen if the treasury issued too few or too many T-bills to satisfy investors’ appetites? That’s easy. There would be a scuffle. If they were too few T-Bills for sale due to a smaller government deficit, then Aunt Tilly would wrestle with the other investors for the limited supply. This would drive T-Bill prices up and interest rates down.
Too Few New T-Bills
If the government ran up the deficit and there were too many T-Bills for sale, then the Treasury would be forced to lower their asking price to sell their inventory. T-Bill prices would fall and interest rates would rise.
Too Many New T-Bills
It is only to the extent that budget deficits exceed Aunt Tilly’s appetite for new securities that they can be said to push interest rates up at all. In our example, we can think of the $357 billion from the previous example as the interest rate neutral budget deficit—one that will put no pressure on interest rates. The balanced budget that we all wish for would actually exert downward pressure on interest rates every year. Over time, government debt would gradually become extinct like the dodo bird; it would be irrelevant for investors.
This does not mean that I love budget deficits. It does not mean that deficits are good or bad. And it does not blunt the fact that higher government spending uses tons of resources and creates all sorts of incentive and resource allocation problems. It just means that budget deficits are unlikely to be a factor in determining interest rates in the range in which we have historically seen them.
If deficits don’t determine interest rates, then what does? The answer is any factor that could drive a wedge between the relative returns on different assets. Higher inflation does that by increasing the return on tangible assets (i.e., the gain on owning a home raises its return) relative to returns on securities. That makes people sell securities to increase their holdings of real assets, like we saw during the 1970s, which drives interest rates higher. Lower income tax rates increase the after-tax returns on taxable securities relative to real assets, for example, because people are forced to report all income from securities on their tax forms but are not required to report the value of living in their home as taxable income. This will drive interest rates lower. Rising productivity growth can quicken net worth growth, which will increase Aunt Tilly’s appetite for all assets and drive interest rates lower. And the Fed can influence the rate of net worth growth by making it easier or more difficult to finance investments.
JR
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The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.
Bank Reserves
The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.
This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.
Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.
My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.
The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.
The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.
Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.
If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.
Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.
It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.
JR
Yesterday I posted a piece about inflation and interest rates arguing that although recent inflation numbers have been very tame, the tsunami of bank reserves (=800%) released by the Fed is beginning to show up in inflation expectations, which is why long Treasury yields are rising. I ended with a warning that long-term bonds, not stocks, are the riskiest assets in our portfolios today.
A good friend asked me to review some of the logic in more detail. I will do so below:
1) The link between rising interest rates is not just a theory that might or might not be true. It is the definition of an interest rate, or yield.For example, In the chart below, if you pay pay $95.24 to buy a bond (really just an IOU) that promises to pay you $100 in one year then we would calculate its yield as r = ($100-$95.24)/$95.24 = $4.76/$95.24 = 5.0%.If something changes in the marketplace and people lose interest in owning bonds so that their price falls to $90.91 then we would calculate their yield to be r = ($100-$90.91)/$90.91 = $9.09/$90.91 = 10.0%.SO, SAYING THAT INTEREST RATES GO UP FROM 5% TO 10% IS THE SAME EXACT STATEMENT AS SAYING THAT BOND PRICES ARE FALLING.2) the interest rate, or yield, (which is just a calculation we make by dividing a contractual interest payment by the price we pay for the security) on all sorts of securities rises and falls with inflation (actually expected inflation. Bet way to understand this is to think of the inflation rate as the “interest” you receive from owning a tangible asset like a house or a bar of gold. If you buy it for $100 this year and its prices goes up to $110 in one year (10% inflation) then the “yield” on the asset is $10/$100 = 10% (the increase in value divided by what you paid.)The logic is; inflation goes up => “yield” on real goods goes up => that makes the yield on real goods high compared with the yield on bonds and other securities => that makes people sell bonds to buy more houses and other hard assets => that pushes hard asset prices up and bond prices down => Falling bond prices increases the yield. => SO YOU DON’T WANT TO OWN BONDS WHEN THEIR PRICES ARE FALLING.3) Over long periods the price level will be roughly proportional to the money supply. The money supply is roughly proportional to bank reserves. The Fed has increased bank reserves by +800% since last September. Together these mean that there is a big increase in the price level, hence inflation, baked into the recent Fed policy. When the economy starts to look a little more normal again (it is starting to do this already) people are going to worry about inflation unless the Fed does something to reverse their actions over the past 6 months.Moral of the story–you don’t want to own bonds when people start worrying that inflation, hence interest rates, will go up.JR
Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?
April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.
Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier.
So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.
You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.
So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.
I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.
Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.
I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.
This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.
JR
