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®

2018 economic forecast

2018 Midyear Outlook: Will the Economy and Markets Keep Growing?

After the performance we saw last year, we had high hopes for the economy and markets in 2018, but the first half of the year was disappointing. Expectations softened as the stock market pulled back early in the year, economic growth slowed, and risks—largely in trade—rose. As we hit midyear, though, those initial hopes appear to be more realistic than they were even a month ago.

For example, job growth has accelerated this year, bringing us, more or less, to full employment. And with continued wage income growth and ongoing high confidence, consumers are both able—and willing—to spend. Businesses are confident, too, and business investment is showing signs of accelerating. Meanwhile, tax cuts and fiscal stimulus have taken government from a headwind to a tailwind.

With this foundation, we should see continued growth in the second half, fueled by the following:

  • Employment—which is likely to continue to grow, albeit at a potentially slower pace than in the first half of the year
  • Businesses—which should keep and even increase their investment as capacity utilization rises and labor becomes scarcer
  • Government spending—which should continue to revert to growth now that the tax cuts and spending deal are in place

What does this mean, then, for real economic growth? We can expect to see growth of around 3 percent, with the potential for better results. Assuming consumer spending growth of around 3 percent, business investment growth near 5 percent, and government spending growth around 2 percent, this 3-percent figure appears both reasonable and achievable. Combined with an anticipated inflation level of 2 percent for the year, nominal growth should approach 5 percent.

Opportunities and Risks

As always, there are risks to this outlook—both to the upside and the downside.

Looking at the economy, if wage growth increases, consumer spending power could increase more quickly. If consumer borrowing were to pick up, spending could grow even faster. Business investment could respond to improving demand and rise more than expected. Local and state governments could increase investment and hiring more than expected.

Politics presents the greatest risk on the downside. Here in the U.S., the midterm elections will certainly disrupt the political process. If it appears likely that Democrats will take one or both houses of Congress, it could raise substantial economic uncertainties. In the nearer term, the administration’s trade policies could disrupt supply chains and increase costs, which would have consequences for financial markets. Abroad, risks include North Korea and continued political turmoil in Europe. Any of these could result in systemic damage and create real drag on the U.S. economy and financial markets.

Another major downside risk is rising interest rates. In its most recent press conference, the Federal Reserve (Fed) seemed to declare victory on both employment and inflation, which could mean faster rate increases than previously anticipated. Current expectations are for at least two more increases in 2018, and with long-term rates constrained, we could be at risk for an inverted yield curve, which historically has been a sign of upcoming recession.

Turning to the stock market, the rest of 2018 could be quite exciting, in both a positive and a negative sense. Earnings growth should continue to improve overall on the heels of economic expansion, as companies reap the benefits from the tax cuts. As growth accelerates and risks from Europe and North Korea subside, valuations may rise back to previous highs—or even higher on a positive shift in investor sentiment.

There are certainly risks to the market on the downside, however. Valuations are at or above 2007 levels; in other words, they are at historic highs. Profit margins are also at historic highs, and the tailwinds that got them there are disappearing as interest rates rise and wage growth continues to pick up. That’s not to mention that rising interest rates could make bonds more attractive as an investment, which would also weigh on valuations.

Looking at the past three years, a typical lower-end multiple has been 15x forward earnings. Based on current analyst expectations of $176.52 in S&P 500 earnings for 2019, and using a 15x multiple, the 2018 year-end target for the index would be around 2,650, which represents a decline of about 5 percent from mid-June levels. This is a reasonable downside scenario for the end of the year.

If the economy continues to grow, and businesses continue to operate at very high profitability levels, valuations could rise back to around 17x forward earnings. This reasonable upside scenario would leave the S&P 500 around 3,000 at year-end, an increase of almost 8 percent above current numbers.

 Are Things Looking Up?

This is definitely not a prediction of a flat, boring market. Absent the Fed’s security blanket, the market should be more volatile, and it likely will be. A sell-off at some point in the next six months is very possible, with the rising concerns about trade one potential cause. In addition, as rates rise, investors will likely reassess the attractiveness of U.S. stocks versus fixed income. Meanwhile, accelerating wage growth should have a negative effect on profit margins, even as it boosts the economy as a whole.

While the downside risks are real, the ongoing strength of the U.S. economy should protect us from the worst and even continue to offer some upside. The second half of 2018, therefore, seems likely to provide us with more growth in the real economy and financial markets.

Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.

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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.

© 2018 Commonwealth Financial Network®