Many investors expect interest rates (and yields) to keep rising, and it’s hard to argue with them.
But there’s an alternative school, of which I’m part, that says U.S. investors may see lower rates in the offing. That’s why I recommend that, if you still own bond funds, hold on to them.
Last week I wrote in my column that slow inflation and sluggish economic growth will put a cap on rates. This week I’ll discuss why three other factors suggest we’ll see lower rates for at least six months and probably 18 months.
Consumers haven’t healed from the Great Recession. Most U.S. families’ incomes haven’t risen, and jobs have been hard to come by. That means, based on the standard of living in the U.S. (as measured by real median household income), the recent recovery has entirely bypassed the consumer sector.
While it’s normal for the standard of living to contract in recessions, this is the first time — deep into an expansion — that it has continued to erode. As the chart below shows, the current standard of living is unchanged from 1995.
In spite of some seemingly marginal job gains in the first half of 2013, a closer examination of the numbers reveals that conditions have actually gotten worse. That’s because about three-quarters of the increase in jobs so far this year have been in four of the lowest-paying industries: Retail; temporary-help services; hospitality and leisure; and nursing- and residential-care facilities.
In fact, Lacy Hunt, the chief economist at investment-management firm Hoisington Investment Management, reports that during the first half of 2013, part-time jobs increased at an average rate of 93,000 per month, while full-time jobs averaged increases of only 22,000 per month. That puts full-time employment as a percentage of the adult population near its lowest point in three decades: 47 percent.
The shift to part-time employment likely reflects business’ efforts to reduce the increase in health-care costs associated with full-time employment under the Affordable Care Act.
Moreover, with individual income taxes on the rise, conditions will continue to deteriorate. That’s because when taxes are increased (as has recently occurred), the initial response of households is to lower their savings rate rather than to immediately reduce spending.
This explains the sharp drop in the personal savings rate to 2.7 percent in the first five months of this year to a level at or below the entry points of all the economic contractions since 1929. The 2013 slump in the savings rate is a painful indicator of the real economic adjustments that lie ahead, and also an additional restraint on economic growth.
There is a two- or three-quarter lag in consumer-spending reductions after a tax increase is put in place, several academic studies show. That’s why I expect the main drag on growth to occur in the third and fourth quarters of this year, with the negative trend continuing for another two years.
Some in the mainstream media have said that the expiration of the “temporary payroll tax cut” will have no effect on spending as the initial increase in income wasn’t seen as permanent, but the facts refute this view. The average monthly annualized growth rate of real personal income (less transfer payments) for 2011 was 3.4 percent, and in 2012 it was 2.2 percent. So far this year, with the payroll-tax change in effect, the average is 1.8 percent through May.
|Wal-Mart’s drop in sales and cautious outlook for the rest of the year, points to a decline in consumer spending.|
And slower income growth has curbed spending, with average monthly annualized growth rates of 2.5 percent for 2011, 1.9 percent for last year and 1.8 percent through May of this year. I expect this trend to continue for some time.
As evidence that we may indeed be on the verge of a slump in consumer spending, Wal-Mart last week announced disappointing sales. Since Wal-Mart is seen as a barometer for the broader economy, this negative news sent the benchmark S&P 500 sliding 1.3 percent.
Monetary and Fiscal Policy
It’s well-known that central banks around the world have pumped trillions of dollars into the economy — more than $3 trillion in the U.S. alone — and the Federal Reserve has kept the federal funds rate near zero.
However, what’s little-known is that the effect of each round of quantitative easing has been the opposite of the Fed’s intentions. By providing more liquidity, the central bank had hoped to lower long-term interest rates. Instead, rates have risen, and when securities purchases were discontinued, yields fell (as shown in the chart below).
The Fed can’t control long rates because they’re affected by inflation expectations (as I explained in last week’s Money and Markets column), not by supply and demand in the bond marketplace.
While at first this may seem counter-intuitive, consider the following: When the Fed buys Treasuries, existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates.
Following along this same line, when the Fed stops this program, inflation expectations fall because it creates a market demand for Treasuries, bringing rates back down.
That’s why the Fed’s quantitative policies have been counter-productive to growth but have been great for the stock market — as interest rates have risen during each period of quantitative easing — which you can see in the following table.
Moreover, during quantitative-easing programs, commodity prices and inflation rose temporarily.
On the other hand, real household income (as shown in the chart at the top of this column) has not responded.
Thus, higher interest rates during the QEs and the drop in real wages have had the unintended consequence of increasing the income and wealth gap. Unfortunately in the real economy, this means many more U.S. households were hurt, rather than helped, by the Fed’s efforts.
History Points to Lower Rates
In the aftermath of the debt-induced panic years of 1873 and 1929 in the U.S. and in 1989 in Japan, the long-term government bond yield dropped to 2 percent between 13 and 14 years after the panic, as shown below. The U.S. Treasury bond yield is tracking those times, which provides further evidence that the low in long-term rates is still in the future.
That’s why I’m recommending that if you’re a bond-market investor, stay calm for a bit longer and see if interest rates begin to back off, as I suspect.
Don’t forget to check out our Facebook page, where I’ll discuss a rule on interest rates that dates back 45 years. It says, in general, that rates rise and fall quite a lot all the time. Click here to see Money and Markets’ Facebook page.