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Tuesday, April 28, 2020

CARES Act and Sub-Zero Interest, Part 2

One of the strong points of the U.S. economy in comparison with Europe has been that we have had higher GDP growth and sounder monetary policy. That is about to change.

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Last Monday I explained that the U.S. Treasury has already put us on a path to sub-zero interest rates:
With only 20- and 30-year Treasury bonds yielding above one percent, the U.S. Treasury has now brought the American economy within a hair split's distance of Europe, where negative treasury rates have been in effect for several years. This promulgation of sub-zero interest rates has been driven in good part by a striking, recent rise in demand for Treasurys with a maturity longer than five years.
I also predicted that:
The flight into long-term Treasurys has pushed the interest rates down from the top, a trend that is going to continue as Congress goes to work spending out the CARES Act appropriations. If the market will not absorb more government debt - and there are signals that the banking system i s saturated - the Federal Reserve will spring into action.
Not a lot has happened in terms of money printing, but as Figure 1 explains we have continued our slow drift down toward sub-zero interest rates. The grey area represents the interest rate on the one-month Treasury bill, which is the shortest, while the blue area reports the rate on the 30-year, and longest Treasury bond. The dashed line represents the difference between the two:

Figure 1
Source: U.S. Treasury

As the dashed line suggests, the shortest rates have made lasting contact with the zero level. In fact, the seven-day average daily rates for Treasurys (as of Monday April 27) shows that every bill and note with a maturity of five years or shorter is now stuck with yields of less than one half of one percent. Only the ten- and thirty-year bonds yield more than one percent (1.0 and 1.2 percent, respectively).

For comparison, on February 28 every single one of the 12 Treasury maturity categories yielded 1.5 percent or more.

The difference between 0.1 percent - the current yield on a one-month Treasury bill - and 1.5 percent may seem immaterial, and for the longer-term investor it is. However, for anyone trying to save for the longer term by owning government debt these small differences matter a great deal. Suppose you wanted to invest $100,000 of retirement savings, spread evenly across the 12 maturity categories, from one month to 30 years. Given the average interest rate:
  • On February 28 you would have earned $1,170 per year; 
  • Two months later you could only expect to earn $430 per year. 
Over ten years, the higher interest rate gives you almost 8.6 times more money than the lower rate.

When you aggregate this difference across the economy, it is a substantial deprivation of household wealth build-up. Retirement savings obviously do not all go into Treasurys, but since they have always been considered rock-solid reliable they are the anchor of the portfolio for any thoughtful investor. With yields plummeting, more investors are forced into the stock market for compensation.

There, of course, risks are aplenty, and stocks only become riskier as more money goes after them.

Which brings us to the next phase of the sub-zero scare, one that we will have to cover in two steps. First, the theory.

Stock markets reflect the profitability of the production capacity of an economy: the better the economy performs, the stronger the stock market will be. Speculation inserts a wedge between the economic fundamentals and actual market values; the bigger the wedge becomes, the more risk the individual investor is exposed to.

The speculation wedge grows for two reasons: investors have more money to speculate with; and the economy grows more slowly. In a sound, nicely growing economy there will be an interaction between these two variables: at some points the infusion of speculative money will drive the market; at other points economic growth will be a more decisive factor.

When, on the other hand, growth is slow and remains slow for an extended period of time, speculation takes over as the driving force of stock market values. We have seen this happen in the past 20 years. In Figure 2, the SP500 market value is contrasted against current-price GDP:

Figure 2
Sources of raw data: NASDAQ (SP550); Bureau of Economic Analysis (GDP)

Since about 2000, the economy has grown notably slower than it did in the last half of the 20th century. That alone has grown the speculative wedge, but on top of that we have the plunge into cheap money. First came the monetary stimulus in response to 9/11, then we had Bernanke's Quantitative Easing. Janet Yellen phased it out and Jerome Powell has struck a difficult but prudent balance between, on the one hand, a perennial budget deficit and the Trump administration's expressed interest in more cheap money, and on the other the need to reduce the risks of negative consequences from big money printing.

One of those consequences is the plunge in interest rates, and its ramifications go beyond sending the stock market into a speculative frenzy. There are three macroeconomic effects to keep in mind:

1. Short-sightedness and slow growth. Speculative gains on the stock market are short-sighted and allow people looking to make money on their investments to cash in big and fast. There are, of course, also significant risks, but if an investor's portfolio is dry enough his threshold for risk toleration will adjust accordingly. This means relatively less money going into productive, long-term investments with deferred gratification, so to speak. As a result, the capital stock and the workforce do not develop their productivity and skills as much as would otherwise be the case. As a result, growth slows down over time.
2. Over-indebtedness and slow growth. Low interest rates, especially below zero, cut the price of credit while making savings pointless. It pays to go into debt but it does not pay to build the economic value that repays the debt. Increased indebtedness is a short-term boost for the economy, but as debt levels build and principal payments claim more and more of our personal income, household spending is gradually depressed. Debt works like taxes: the principals pay for something other than your own current expenditures, forcing you to reduce your standard of living. The difference, of course, is that debt is voluntary, but from a strict economic viewpoint it has the same effect as taxes do. 
3. Big welfare state and slow growth. Perhaps the most damning consequence of cheap money is that government continues to spend, even as tax revenue lags behind and the deficit grows bigger. At zero interest, government never has to pay back its debt, or even make interest payments. New debt pulls in new cash, and all that the Treasury really has to do is roll over existing debt with regular intervals. Deficits are politically cheaper than taxes - nobody complains about voluntarily giving up their money to government - and there is virtually no limit to how big the welfare state can grow. The problem, of course, is that the bigger government gets, the slower the economy grows.

Once we dip into sub-zero interest rates, these three effects ominously merge into one big macroeconomic quagmire. We saw the slowdown in business investments during the crawling Obama recovery, with lasting growth effects that were repaired only in the last couple of years. We saw the sluggishness in consumer spending already during Bush Jr., as consumer debt levels built as dark clouds over family finances. 

The burden of consumer debt did not ease up until Trump's first term. Since then we have seen a solidity in consumer spending that reinforced an already-strong economy. That is bound to change for the worse again, if our interest rates go negative.

Deficit spending has been the way of every president since Lyndon Johnson; the exception is Clinton in his second term. The more cheap money Congress can get its hands on, the more they will spend; while President Trump has a budget for FY2021 that would shrink the deficit, a more likely scenario going forward is more spending on borrowed money. That may not be the president's wish, but unless he can make budget balancing his top priority, he will have to accommodate a spending-hungry Capitol Hill.

When capital formation suffers from short-sightedness; when debt costs hamper consumer spending; when government spending takes up more and more space in the economy; the inevitable result is economic stagnation. This is not just a theory - it is harsh reality in Europe. We will look at their data in Part 3. Stay tuned.

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