A few friends have expressed the belief that interest rates have nowhere to go but up. This, of course, has been the mantra of the market for the past several years, and, perhaps, my friends have been listening too long to the talking heads on bubblevision.
Here’s why it won’t happen: Today’s U.S. economy has many similarities to that of 1990s Japan. These include asset bubbles (equities), high debt burdens (including soaring margin debt), deflationary pressures, tepid economic growth, weak productivity, a stagnant labor force, and aging demographics. In 1997, 10 Year Japanese Government Bonds (JGBs) yielded 2.3%. Today, 20 years later, those same JGBs yield 0%. To follow the analogy, today, 10 Year U.S. Treasuries yield, 2.3% … You see where this logic goes? Given the similar economic characteristics between today’s U.S. economy and that of 1990s Japan, if you think that U.S. rates have nowhere to go but up, perhaps a look at this recent history can be informative.
Inflation is a major component of long-term interest rates, and inflation is what bond bears, like Alan Greenspan, hang their hat on when predicting higher interest rates. But, inflation is really nowhere to be found in the modern world:
• The PCE deflator (used to be the Fed’s favorite) rose at a seasonally adjusted annual rate (SAAR) of 0.3% in Q2. This measure has been below the Fed’s 2% target 62 months in a row and 101 of the last 105.
• In Canada, inflation has been less than 2% 63 months in a row and 90 of the last 95;
• In the Eurozone, that same data is 101 months in a row and 132 of 149;
• In Japan (adjusted for the impact of sales tax increases), the numbers are 104 months in a row and 229 of 232.
What makes anyone think that this is going to be reversed anytime soon?
As an aside, there aren’t too many practicing economists today who were prognosticating in the inflationary spiral years of the 1970s. Back then, if someone would have opined that 40 years later, little to no inflation would be the major concern of the Fed, that person would have been laughed out of the room. Back then, stable prices were the major objective of monetary policy. Times certainly have changed!
We had the first pass at Q2 real GDP growth on the last Friday in July (and the Commerce Department will update that on the last Fridays of August and September). That initial estimate was a real growth rate of 2.6%, certainly higher than my expectation (Q1 growth was revised down from 1.4% to 1.2%).
Much of the initial GDP estimate comes from assumptions and models, as a significant portion of Q2 data is unavailable at the end of July. The models rely on the sentiment indexes (like the ISMs) which, for the last two quarters have been quite poor at forecasting the hard data. For example, the 2.8% growth in consumption in the GDP estimate simply doesn’t square with most of the hard data reports, housing, autos, and the rising delinquencies in the consumer credit sector. A new report shows consumer spending barely rose in June. Therefore, it is highly likely that the subsequent GDP estimates will show lower consumption spending and lower GDP growth.
I mentioned housing. Let’s look at Q2 housing data (SAAR):
• Building Permits: -13%
• Housing Starts: -22%
• Sales (Pending and Existing): -4% (Pending did rise 1.5% SAAR in June)
• New Home Sales: -12%
Because home prices are rising rapidly, even small changes in interest rates have major impacts on monthly payments, yet another reason rates can’t sustainably rise.
I also mentioned autos. Here are the monthly sales of new cars beginning with the December, 2016 peak number (millions of units, SAAR): 18.319, 17.497, 17.442, 16.523, 16.815, 16.582, and 16.409 (June). Notice the pattern? The automakers reported very weak July sales, a continuation of rising inventories, and the highest level of “days to sell” since July ’09.
One can often tell the state of the consumer by the health of the consumer lenders. In Q2, Synchrony Bank’s charge-offs rose to 5.42% of loans, vs. 4.51% a year earlier, and their loan loss provision was up 30%. Capital One’s charge offs were 5.11% in Q2 vs. 4.07% a year earlier, and American Express, thought of as a lender to the upper echelons, raised their loan loss provisions by 26%. In and of themselves, these don’t spell recession. But they do speak to a tired and weakening consumer.
Sky High PE
Despite the supposedly great Q2 earnings, this has not been an earnings induced market run-up. It is a run-up caused by a rise in the earnings multiplier (the PE ratio). At 30x, the CAPE ratio (Robert Shiller’s Cyclically Adjusted PE) has only been higher than this in the late 90s and in 1929 (it never got as expensive as it is today in ’07!). Its historical average is 17x. So, if you believe in mean reversion…
The Fed has (thankfully) formally changed its stance on rate hikes, now acknowledging that the deflationary forces at play are much more than “transitory.” But it is a scary thought that they held that “transitory” position for so long, and in the face of such compelling evidence to the contrary. In the end, tepid economic growth and zero inflation really give the Fed no reason to further tighten monetary policy, at least from an economic growth perspective. However, the FOMC’s minutes make it clear that they are now concerned about the price excesses in the equity markets.
A slow growth economy is susceptible to extraneous events (North Korea?), or poor policy choices. So far, the Trump administration has had little success in moving its pro-growth agenda. Much needed tax reform could help, but that now appears to be a 2018 hope. A desperately needed infrastructure spending program looks to be even further off. (I suspect the Congress will get serious about it as a measure to help the country climb out of the next recession – so we’ll have to wait till then.)
With fiscal policy paralyzed, that leaves monetary policy as the only unconstrained tool. Given tepid economic growth, even a small monetary policy misstep could have negative repercussions and push the economy over the recession ledge. The recently confused Fedspeak regarding inflation’s path forward, the latest FOMC minutes, and the announced policy of balance sheet reduction (negative QE) diminish my already low level of confidence that such a policy error will be avoided.
Robert Barone, Ph.D.