Lower for longer interest rates

Another Look at the Dollar: The Fed and Interest Rates

Re-posted by Matthew Lang, Lang Investment Services

July 30, 2020

One of the reasons behind the recent decline of the dollar is reportedly the fact that the Fed has largely committed to keeping rates low—the market believes—forever. Looking at the yield curve, the 30-year Treasury rates are at 1.22 percent as I write this. With rates that low, the value of the dollar would certainly take a hit if other central banks raised rates.

Another way of looking at the dollar, then, is to determine whether the Fed is likely to raise rates. We can’t look at this possibility in isolation, of course. We have to evaluate what other central banks are likely to do as well. If everyone keeps rates low, then no problem. If everyone else raises rates and the Fed doesn’t, then the dollar would face headwinds. And, of course, if the reverse is true, then the dollar would have the wind behind it.

Every central bank, including the Fed, will make its own decisions, but they all have similar constraints. If we look at those constraints, we can get a pretty good idea of which banks will be raising rates (if any) and when.

Inflation

The first constraint, and the one that makes most of the headlines, is inflation. Right now, the fear is that the governmental stimulus measures, here and abroad, will drive inflation meaningfully higher and that central banks will be forced to raise rates. In that context, even if the Fed remains committed to lower rates, then other central banks will be forced to raise theirs, bringing us back to the first sentence of this post.

The problem with this argument is that we have heard it before, multiple times, and it has always proven false. Inflation depends on an increase in demand, which we simply do not see in times of crisis. The U.S., until at least the time the COVID pandemic is resolved, will not see meaningful inflation. Other countries, while less affected by COVID, have their own problems, and inflation is not likely to be a problem there either. Neither the Fed nor other central banks will be raising rates in any meaningful way. The argument fails. No problem.

The employment mandate

The second constraint, and one that is underappreciated, is that central banks have a responsibility to keep the economy going. Here in the U.S., that responsibility is expressed as the employment mandate. The Fed is explicitly tasked with keeping employment as high as possible without generating inflation. Raising rates will act as a headwind on employment. So, in the absence of inflation, the Fed has no need to raise rates. With employment not expected to recover for the next couple of years, again no problem with lower rates.

Other countries have the same issues, with the same results. Inflation is low and steady in all major economies, and unemployment is high in the aftermath of the global pandemic. For at least the next year and more, none of the central banks will face any pressure to raise rates—in fact, quite the reverse.

Lower for longer

The Fed will not be the only one holding rates low. The Fed has a press conference this afternoon where it is expected to repeat the “lower for longer” mantra. Other central banks are doing the same thing. Right now, the economy needs the support, and inflation is not a problem.

One question I have gotten is whether the Fed will implement some form of yield curve control and what that will mean for investors. Whether the Fed makes it explicit or not, I would argue that control is what we already have, and we have seen most of the effects already. Lower for longer has supported financial markets, and it will likely keep doing so. The Fed does not need to make it explicit, since it is doing so already.

Governmental finances

Looking beyond monetary policy and macroeconomics, there is another reason rates will likely remain low, which is that governmental finances will blow up if rates rise. At meaningfully higher rates, governments will simply not be able to pay their accumulated debt. All central banks are aware of this outcome, even if they do not talk about it. As far as the Fed is concerned, I suspect that not blowing up the government’s finances comes under the heading of maintaining maximum employment. It’s not an explicit objective, but it is a necessary one.

The wait for growth to return

Until we get growth, we will not get inflation. Without inflation, we will not get higher rates. With the U.S. likely to be ahead of the growth curve, as it has always been, the Fed will likely be the first to raise rates, not the last, with a consequent tailwind to the dollar’s value. Wait for growth to return, and we can have this discussion then.

That will not be soon though.

Matthew Lang is a financial advisor located at 236 N Washington St, Monument, CO 80132. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 719-481-0887 or at matt@langinvestmentservices.com.

© 2020 Commonwealth Financial Network®

Virus Hysteria

Virus hysteria

Dear Clients and Friends,

As we are all aware this last 3 weeks has been bad for the stock market. The market has dropped just under 20% from the peak as of yesterday’s close. Many of you are nervous and that is understandable. Over the last few weeks, a virus scare has become a hysteria. In my 22 years as a financial advisor I have never seen a hysteria quite like this one. In a small way it reminds me of a more extreme version of Y2K scare … stockpiling dry goods, worry about the unknown, and massive media hype playing into the worst parts of our fears. One thing I have learned through experience is every market drop is different … yet every market drop is the same. We now look at Y2K with a historical view, but the panic people felt at the time was real. My office is here to talk to you if you have concerns, questions or just want to status reports. Please don’t hesitate to call.

As part of my due diligence process, I find the smartest, best people and listen to what they have to say. Let me share an analysis from one of them.

Stephen Auth, Chief Investment Officer of Federated Investors wrote:

Given the novelty of this virus, we have no perfect template to answer some very key questions that ultimately will affect the outlook for the global economy and financial markets. How far will the virus spread? How long will it last? How many people in each country will be infected and worse, die, as it progresses country by country? No one knows, and most scientists, lacking the data, are unwilling to project potential outcomes. So we need a framework for understanding the data as it comes in and for projecting the trend and, importantly, the change in the trend. Here are the key stats we are following:

Virus progression in China: Slowing. China arguably is the key country to watch since the virus started there. Importantly, it is a “worst-case scenario” for how the epidemic will unfold because the flu got a more-than-usual head start in establishing itself, in part because the government blacked out news flow about it for weeks and because China’s health-care system is less advanced than in the developed world. So it’s good news infection rates in China already have begun to slow to just 3% per week, far below the explosive growth witnessed early on and is now occurring (off very low initial numbers) in the U.S. and Europe. If the weekly new infection rates in China continue to decline, that would portend positively for the path of the virus in the developed world. But if it reaccelerates, that would imply the virus is likely to enter a dangerous second growth phase even after the first phase fades. We’ll see.

Virus progression in Korea, Japan, and Italy: Still expanding. These are the next countries to watch. The virus landed there sooner than the U.S. and should peak sooner as well. If that occurs in these three countries within the next two to three weeks, consistent with what we’ve seen in China, markets will breathe a sigh of relief even if the expansion in the U.S. and Europe continues. But if the virus continues to expand in these early-stage countries, markets will begin to discount the possibility of a longer-term disruption in commerce and ultimately earnings.

Virus progression in the U.S.: Still expanding in the very early phase. For the next two to three weeks, we expect a daily drumbeat of new and ever-growing numbers of cases and cities with infections. Like China, once better and more available testing kits/protocols are deployed in the field, an alarming “sudden” jump in detectable cases is probably on the horizon. Ultimately, we doubt the U.S. markets will fully stabilize until U.S. infection rates begin to decline.

Virus progression in the presently hot, humid climates of the Southern Hemisphere: Low. We view the progress of the virus in hotter countries where it already has been introduced as accidental experiments that will help the markets answer a central question: like most others before it, will this flu epidemic be bailed out by the warmer weather only a few weeks away in developed Northern Hemisphere countries? Or is this new Covid-19 virus a monster than can better survive warm weather? With only 83 of a total of 97,886 worldwide cases of the virus reported occurring through yesterday in Southern Hemisphere countries, our base case is the former but we acknowledge the risk of the latter. If infection rates in the warmer countries above remain low, markets will take this as good news.

He went further to write:

Our view is the underlying health risks are potentially serious but likely overstated. Nonetheless, there remains a risk the economic impact is exaggerated by the individual reaction of the millions of market-economy participants operating within a collective, fear-driven crowd psychology (see insert at bottom). We are more worried about demand destruction than supply-side disruption, but are watching both.

Supply-side disruption measures: Limited so far. Supply disruptions can be dangerous because as shortages of key products and services needed for the global economy to operate smoothly develop, the overall economy can start to sputter and eventually stall. If iPhone components become unavailable, iPhone production inevitably will slow. With less iPhones in retail stores, iPhone sales inevitably will slow as well. Etc., etc., etc. China is the epicenter of this argument, largely because it is a crucial global supply chain source and because in its attempt to arrest the spread of Covid-19, it literally ordered key production centers to shut down temporarily. The good news is factories there are starting to come back on line, and so far, few other production centers have shut down. This makes sense. Most modern factories are highly automated, and if necessary, could be operated by workers in protective gear if there was a buck to be made. We are watching for both anecdotal reports of further supply disruptions, along with published weekly economic series such as rail and truck volumes. So far we classify this risk as “limited.”

Demand-side disruption: Limited but growing Demand disruption is the key risk ahead. As the public panics over the flu, and/or governments and corporations take preventive measures, we likely will experience additional demand disruption already hitting airlines, cruise ships, casinos, hotels and other components of the travel and leisure industries. Key potential weak spots include restaurant traffic in large cities, mass transit ridership and mall traffic. At the moment, most of these indicators are holding up, but we expect them to begin worsening in coming days. How long this will last will depend a little on the public’s perception of the risks of being out and about, even if everyone is taking normal precautions to limit the virus spread. Our view is that within a few weeks, the public in general will begin to assess the risk of the virus spreading more realistically, and with it, commerce in the retail side of the economy will begin to stabilize and even re-accelerate. Key indicators we are following include weekly series such as hotel occupancy and movie ticket sales.

Liquidity events: None so far. A third area we are monitoring closely are liquidity events that grow out of either supply or demand disruption. In 2008-09, this actually was the core of the crisis, as the temporary downturn in real estate markets, of which the banking system held levered positions, produced a temporary impairment of bank capital ratios. Because banks largely are funded overnight through demand deposits and/or the commercial paper market, this exposed them to a systematic withdrawal of cash at the same time, spawning a massive chain reaction of called loans and defaults that shut down borrowers, cut off credit and tanked the economy. This time around, the banking system is healthy. But in some ways, we do have a temporary systematic force at work: the potential for retail businesses suffering from a sudden drop in sales and cash flows. Another weak spot could be oil producers suffering from temporarily depressed spot prices and volumes. Many of the former are small businesses that both power the economy and, along with some of the latter, are highly levered. So we are watching for signs of stress that could suggest they are in danger of going under through, again, anecdotal bottom-up evidence from our stock and high-yield teams, along with such indicators as the National Federation of Independent Business small business confidence index and Challenger Gray’s measure of layoffs due to bankruptcies. Our base case is that given the systemic nature of the problem, corporate landlords and bank lenders are likely to extend terms until the storm passes rather than throw all their loan and rental customers under the bus at the same time. We’ll see. If bankruptcies begin to rise, it would be a sign that a liquidity crisis is emerging. And that in turn could lead to the next area we are watching.

Negative feedback loops: None so far Given the size of the publicly traded corporate credit markets and their increased importance in funding companies around the world, a freeze-up here could create a liquidity crisis that leads eventually to bankruptcies, rising unemployment, lower demand, lower earnings and still higher credit spreads, creating a reflexive feedback loop in the capital markets that takes on a life of its own. This is why we expect the Fed to remain focused on liquidity infusions (more below). In a related vein, we are watching the stock market itself, both for signs of compelling valuation and for potential negative wealth effects if the decline becomes long lived. And we are watching the potential for political feedback loops. That is, if the virus is quickly contained and the economy resumes its upswing, President Trump’s approval ratings should rise and the prospect of four more years of his pro-growth policies likely would buoy markets. On the other extreme, if things get so bad that voters become disillusioned with capitalism as an economic model, Bernie Sanders could rise in the polls and begin to take the delegate count lead again in the Democratic primaries. Joe Biden, now the Democratic front-runner, is probably viewed by the markets as market neutral.

Employment declines: Low so far. The fourth area we are watching is employment, the heartbeat of the economy. If businesses disrupted by the forces noted above begin to take more drastic countermeasures, such as laying off workers, our base case of a likely short economic disruption could extend to something worse, potentially a recession. The first sign of this happening will be employment. This will show up in key indicator series, especially weekly jobless claims data and, monthly, ADP’s tally of payroll growth among small companies (under 50 employees), the government’s count of non-farm jobs in the retail and leisure & hospitality industries, and Challenger Gray’s survey of layoff announcements. So far, so good.

The chess game of policy reaction

A third broad area of the present crisis is public policy reaction to mollify the impact of the pandemic on the global economy. Here, most of the talking heads have been, frankly, less than helpful. They conflate random various public policy tools, codifying them all as simply “stimulus measures.” Specifically, we are watching for following potentially helpful policy reactions:

Liquidity provision measures. Already underway, these key measures are vital. If we are right about the likely path here, the major near-term risk to the economy is that a short-term liquidity crisis, particularly among small businesses, morphs into store closures, bankruptcies and rising unemployment. So the monetary authorities in particular need to flood the system with liquidity to help these little businesses survive. This is why we liked the Fed’s sudden 50 basis-point cut, which some characterized as using its “stimulus bullets” too early. This cut should not be viewed as a stimulus bullet, but a liquidity bullet designed to avoid the need for a stimulus bullet. We think the Fed should further bolster liquidity through Quantitative Easing (QE) injections, in particular through direct purchases in the credit markets. This is where the real crunch seems to be occurring and could be the Achilles Heel in the capital markets. Other measures we are watching for include similar central bank action around the world (Hong Kong, Australia, Malaysia and the Fed so far this week), and regulatory relief by the appropriate overseers to encourage larger lenders and landlords to extend terms for borrowers being squeezed by the exogenous and systemic force of nature represented by the virus. (Very different from cutting off a sole borrower whose product/service is simply failing in an otherwise healthy economic environment.)

Short-term fiscal measures that can help with liquidity problems. On the fiscal side, governments have the ability to provide short-term cash to smaller businesses in the form of tax holidays, such as Social Security tax payments. We expect the Trump administration to utilize these in the weeks ahead and if we see them, we will mark this in the progress column.

Larger-scale fiscal measures to jump-start the economy if it heads into recession. Frankly, none are needed so far, as we are not in a recession. But should one come, the government certainly has the ability to legislate for large-scale tax or spending measures to spur the economy. We hope we don’t get to this stage but are comforted knowing that over the long term, such measures are available and likely would be employed.

Investment template: No time to panic

Against all this uncertainty, we are watching for opportunities under the assumption our base case (a short but sharp economic pullback followed by a dramatic back-half recovery) is correct. But we are pacing our investments to allow for a change in course should the areas we are monitoring turn more negative. We already have averaged in 2 points further to equities in our PRISM® stock-bond portfolio model on the first big downdrafts of last week (putting us at 70% of our maximum overweight in stocks), and have plans to add a third point if markets decline a full 20% from their highs. (In the past, 20% downdrafts have proven excellent long-term entry points—even during the 2008-09 crisis.)

At the portfolio level, we are similarly using big market down days to upgrade our portfolios, adding ever-higher quality long-term growth stories at significantly reduced prices. Again, we are advising moving deliberately and confidently into equity positions rather than trying to call a precise bottom amid the current volatility. We are entering the “Be Not Afraid” moment. Follow with us the progress of the crisis for sure, and adjust your strategy accordingly. But above all, remain confident and careful. This is no time for panic.

Everyone take care, please try not to worry. Also, don’t forget to buy 6 years’ worth of toilet paper just in case.

Regards,
Matt

_____________________________
Matthew R. Lang
Financial Advisor

236 North Washington
Monument, CO 80132
Phone: (719) 481-0887
matt@langinvestmentservices.com | www.langinvestmentservices.com

Independent Advice. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. Fixed insurance products and services are offered through CES Insurance Agency.