Yesterday turned out to be a day dominated by the tax cut/stimulus deal struck between President Obama and his Republican opponents. As markets began to concentrate on the implications of the deal we saw some quite considerable swings in what turned out to be rather a volatile day. The day ended with a very different reaction to the initial one. However if we begin at the beginning then economists at the various US investment banks looked at the programme and decided that it would involve a boost to the US economy of around US $960 billion over the next two years. Now one needs to be careful of calling this a full-scale stimulus programme as approximately US $360 billion is the continuation of some Bush-era tax cuts mostly for the well-off, but that still leaves some US $600 billion. Accordingly economic forecasts for growth in the US economy for both 2011 and 2012 were revised higher.
Equity Markets, Crude Oil and Precious metals respond
The initial response of the Dow Jones industrial average was to surge nearly one hundred points to a new recent high of 11,450 as the new improved prospects for the US economy were digested. Moving even more aggressively was the price of a barrel of crude oil as the West Texas intermediate benchmark charged past US $ 90. Precious metals had of course already been rallying on the back of what Federal Reserve chairman Ben Bernanke had said when interviewed on the CBS television programme 60 minutes. So this new stimulus package boosted what was already a strong market and the front month futures price for gold reached US $1432 and silver futures passed the thirty dollars barrier and touched US $30.70.
There is an obvious illogic in the fact that equity prices and precious metals were rallying at the same time as one represents hopes for the future and the other fears for the future. But welcome to a world where official intervention is almost omnipresent leading sometimes to the strangest of bedfellows. The next step though was further reflection and both sets of prices falling. The Dow Jones industrial average retreated back to where it had rallied from and closed at 11,359. However precious metals prices fell heavily and as I type this silver is trading at US $29 per troy ounce and gold has fallen back to US $1396. So the rallies were extinguished and in fact followed by falls. The price of crude oil did the same and is now around US $88 per barrel.
The cause: A surge in long-term interest rates and falls in the prices of US Treasury’s (government bonds)
As the tax cuts/stimulus news hit the US government bond market it took a little while to digest it and decided that it did not like it much. Perhaps it was the fact that the stimulus will require and extra US $960 billion of borrowing which will need to be financed over the next two years or perhaps it was the news that so far the United States has borrowed more than US $ 2,100 billion in 2010, or some combination thereof. In addition I doubt that it helped much that the White House chose to put this on its fact sheet on the agreement.
Does not worsen the medium- and long-term deficit. These are responsible, temporary measures to support our economy that will not add costs by the middle of the decade.
I doubt whether the bond markets bought that one! It might have been better to leave that out as whilst the programme is essentially for two years it will give America a higher fiscal deficit and national debt going forwards once it expires and of course we do not yet know that the Bush tax cuts will not be extended again.Who would have thought that a Democrat President would extend tax cuts for higher earners?
The first sign of problems was in a 3 year auction of Treasury bonds where some US $32 billion was borrowed at an average yield of 0.862%. This may seem low and in absolute terms it is and it is but the significance is that the last auction of such stock took place at a yield of 0.575%. Hard on the heels of the disappointing auction result was the fact that yields on the benchmark ten-year rose to 3.16% and the long bond or thirty year rose to 4.42%. This represented quite a turnaround for markets which had been rallying after Ben Bernanke’s comments on television as recently as Sunday night.
If we return to the subject of Ben Bernanke and the Federal Reserve then one of their objectives from their new round of asset purchases was to reduce longer-term interest rates. I set some benchmarks so we could examine this going forwards and on the day of the announcement of QE2 here they were.
In terms of government bond yields then the ten-year yields 2.57% and the thirty-year yields some 3.91%.
As you can see rather than falls we have now seen considerable rises with the ten-year up by 0.59% and the long bond by 0.51%. Shorter-dated yields have now risen too. Also at these levels Mr. Bernanke’s QE2 must be making a fair-sized loss on its purchases so far.
US housing market issues
One area that has been hit by the rise in Treasury Bond yields has been the US mortgage market. If we look at the thirty year fixed mortgage rate then this fell to just about 4% at the beginning of November. It has been rising and is now 4.55% and if the current move is sustained will go to 4.75%. The fifteen year fixed rate dropped to 3.5% and is now nearly 4%. So what was already a struggling US housing market with all the issues surrounding the foreclosuregate scandal will now by hit be higher mortgage rates. Indeed if yesterdays move is sustained by quite considerably higher mortgage rates.
So set against the hopes of the stimulus programme may be problems for the US mortgage and hence the housing market. As the housing market is a big driver for various areas of the US economy this area will need to be watched closely as it could undo much of the stimulus’ programmes work or even reverse it should the current situation persist.
How effective is the stimulus likely to be?
The Congressional Research Office tried to measure the multiplier effects of the various stimulus measures enacted in the US Recovery Act. It concluded that public expenditure had more of a multiplier effect on the economy than tax cuts. One of the areas it felt had the weakest multiplier of all was the type of tax cuts for high earners that President Obama plans to extend. However a great amount of care is needed with such figures as just to quote one of them the multiplier effect of US federal government spending is estimate at between 1 and 2.5! So the error range is as big as the estimate!
I tend to feel that it overrated the impact of public expenditure and underrated tax cuts. But we agree that tax cuts for the better off members of society apart from being ethically dubious at this time are in fact likely to have very weak economic effects.
As to other implications it will be interesting to see if the rise in longer-term interest rates in the United States is sustained. If it is then not only will she have higher costs financing her debt as she goes forward but the impact of higher mortgage rates will impact on her housing market. This will offset the stimulus programme and it is not impossible that the stimulus programme could end up having a negative effect.
Longer-term interest-rates are rising more generally
We have seen rises in longer-term interest rates around the world recently. There have been individual examples of surges in places like Greece, Ireland and Portugal and problematic increases in Spain and Italy that have left the Euro zone with something of a headache. Well there are always cross-currents in matters like this and the German ten-year bund now yields just over 3% which is up more than 0.8% on its lows. This is significant as so much in the Euro zone is priced off the German benchmark, for a start the various rescue packages are! So “rescue” may not be quite so cheap in future. A general rise in longer-term interest rates is exactly what the Euro zone does not need.
In the UK our ten-year government bond yield went below 2.9% in the summer but closed last night at 3.46% so in spite of the fact that we have performed relatively well there has been a cost here for us. Regular readers will know that I have often compared this yield with our inflation rate and our prospective inflation rate and questioned on this basis the yield. Perhaps events are finally catching up.
Recently we have got used to a world where short-term interest rates have approached zero in what has been nicknamed ZIRP or Zero Interest Rate Policy. In most countries there is little prospect of a rise. However longer-term interest rates are rising and we will have to see if this is a trend which continues. Next year the developed world in one form or another has a lot of money to borrow and it could do without a rise in the cost of this. I realise that there is little debate or media attention on longer-term interest rates but they are in fact often more important than short-term ones. Just because something grabs a headline does not mean it is more important than something else. One of the factors behind the economic growth over my time period of analysing markets has been a fall in longer-term interest-rates.
The Euro zone: The IMF speaks
For once I agree with a public pronouncement on the Euro zone so let me use the words of the head of the IMF Dominique Strauss-Khan as quoted by the Financial Times.
The euro zone has to provide a comprehensive solution to this problem……….The piecemeal approach, one country after another, is not a good one.
Indeed after finding one I find that now some of them are agreeing with me as I have been informed that Bank of Finland Governor Erkki Liikanen stated at a Press Conference today that only half of the estimated 440 billion Euros is useable in the European Financial Stability Facility! They will be agreeing with me (and of course the IMF) on the interest rate being charged to Ireland by the IMF next…
I will be watching closely to see how longer-term interest rates move over the coming days,weeks and months but it would appear that a challenge is being posed to many of the world’s governments and central banks. They are not afraid of intervening in response but we may be reaching a stage where their interventions become even more problematic.
Are you one hundred percent sure of anything?
Having heard Ben Bernanke claim on television that he was one hundred percent sure that he could control US inflation should it start to rise I initially dismissed this as potentially dangerous hyperbole. But it got me thinking about what I am one hundred per cent sure of. In the universe in which we live can we be one hundred per cent sure of anything and if so of what? I will be interested to read your thoughts on this.