How soon will the US national debt be unaffordable?

It is time to look again at a subject which has been a regular topic in the comments section. This is what happens when national debt costs start to rise again? We have spent a period where rises in national debts have been anesthetized by the Quantitative Easing era where central bank purchases of sovereign debt have had a side effect of reducing debt costs in some cases by very substantial amounts. Of course  it is perfectly possible to argue that rather than being a side effect it was the real reason all along. Personally I do not think it started that way but once it began like in some many areas establishment pressure meant that it not only was expanded in volume but that it has come to look in stock terms really rather permanent or as the establishment would describe it temporary. Of the main players only the US has any plan at all to reduce the stock whereas the Euro area and Japan continue to pile it up.

So let us take a look at projections for the US where the QE flow effect is now a small negative meaning that the stock is reducing. Here is Businessweek on the possible implications.

Over the next decade, the U.S. government will spend almost $7 trillion — or almost $60,000 per household — servicing the nation’s massive debt burden. The interest payments will leave less room in the budget to spend on everything from national defense to education to infrastructure. The Congressional Budget Office’s latest projections show that interest outlays will exceed both defense discretionary spending and non-military discretionary spending by 2025.

The numbers above are both eye-catching and somewhat scary but as ever this is a case of them being driven by the assumptions made so let us break it down.

US National Debt

It is on the up and up.

Debt held by the public, which has doubled in the past
10 years as a percentage of gross domestic product
(GDP), approaches 100 percent of GDP by 2028 in
CBO’s projections.

Those of you who worry we may be on the road to World War III will be troubled by the next bit.

That amount is far greater than the
debt in any year since just after World War II

As you can see the water has got a bit muddled here as the CBO has thrown in its estimates of economic growth and debt held by the public so let us take a step back. It thinks that annual fiscal deficits will rise to above US $1 Trillion a year in this period meaning that from now until 2028 they will total some US $12.4 billion. That will put the National Debt on an upwards path and the amount held by the public will be US $28.7 Trillion. Sadly they skirt the issue of how much the US Federal Reserve will own so let us move on.

Deficits

These have become more of an issue simply because the CBO thinks the recent Trump tax changes will raise the US fiscal deficit. The over US $1 Trillion a year works out to around 5% of GDP per annum.

Bond Yields

These are projected to rise as the US Federal Reserve raises its interest-rates and we do here get a mention of it continuing to reduce its balance sheet and therefore an implied reduction in its holdings of US Treasury Bonds.

Meanwhile, the interest rate on 10-year Treasury notes increases from its average of 2.4 percent in the latter part of 2017 to 4.3 percent by the middle of 2021. From 2024 to 2028, the interest rate on 3-month Treasury bills averages
2.7 percent, and the rate on 10-year Treasury notes,
3.7 percent.

Currently the 10-year Treasury yield is 2.83% so the forecast is one to gladden the heart of any bond vigilante. If true this forecast will be a major factor in rising US debt costs over time as we know there will be plenty of new borrowing at the higher yields. But here comes the rub this assumes that these forecasts are correct in an area which has often been the worst example of forecasting of all. For example the official OBR forecast in the UK in a similar fashion to this from the CBO would have UK Gilt yields at 4.5% whereas in reality they are around 3% lower. That is the equivalent of throwing a dart at a dartboard and missing not only it but also the wall.

Inflation

This comes into the numbers in so many ways. Firstly the US does have inflation linked debt called TIPS so higher inflation prospects cost money. But as they are around 9% of the total debt market any impact on them is dwarfed by the beneficial impact of higher inflation on ordinary debt. Care if needed with this as we know that price inflation does not as conventionally assumed have to bring with it wage inflation. But higher nominal GDP due to inflation is good for debt issuers like the US government and leads to suspicions that in spite of all the official denials they prefer inflation. Or to put it another way why central banks target a positive rate of consumer inflation ( 2% per annum) which if achieved would gently reduce the value of the debt in what is called a soft default.

The CBO has a view on real yields but as this depends on assumptions about a long list of things they do not know I suggest you take it with the whole salt-cellar as for example they will be assuming the inflation target is hit ignoring the fact that it so rarely is.

In those years, the real interest rate on
10-year Treasury notes (that is, the rate after the effect of
expected inflation, as measured by the CPI-U, has been
removed) is 1.3 percent—well above the current real rate
but more than 1 percentage point below the average real
rate between 1990 and 2007.

Economic Growth

In many ways this is the most important factor of all. This is because it is something that can make the most back-breaking debt burden suddenly affordable or as Greece as illustrated the lack of it can make even a PSI default look really rather pointless. There is a secondary factor here which is the numbers depend a lot on the economic impact assumed from the Trump tax cuts. If we get something on the lines of Reaganomics then happy days but if growth falters along the lines suggested by the CBO then we get the result described by Businessweek at the opening of this article.

Between 2018 and 2028, actual and potential real output
alike are projected to expand at an average annual
rate of 1.9 percent.

The use of “potential real output” shows how rarefied the air is at the height of this particular Ivory Tower as quite a degree of oxygen debt is required to believe it means anything these days.

Comment

The issue of the affordability forecast is mostly summed up here.

CBO estimates that outlays for net interest will increase
from $263 billion in 2017 to $316 billion (or 1.6 percent
of GDP) in 2018 and then nearly triple by 2028,
climbing to $915 billion. As a result, under current law,
outlays for net interest are projected to reach 3.1 percent
of GDP in 2028—almost double what they are now.

This terns minds to what might have to be cut to pay for this. However let me now bring in what is the elephant in this particular room, This is that if bond yields rise substantially pushing up debt costs then I would expect to see QE4 announced. The US Federal Reserve would step in and start buying US Treasury Bonds again to reduce the costs and might do so on a grand scale.. Which if you think about it puts a cap also on its interest-rate rises and could see a reversal. Thus the national debt might remain affordable for the government but at the price of plenty of costs elsewhere.

 

 

 

 

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How much will interest-rates rise?

The issue of interest-rate rises has suddenly become something of a hot topic and let me open with the words of Jamie Dimon of JP Morgan. From the Financial Times.

Jamie Dimon, head of JPMorgan Chase, has warned that the US economy is at risk of overheating, raising the prospect that the Federal Reserve may soon need to slam on the brakes to prevent wages and prices from rising too quickly.

There are more than a few begged questions here but let us park them for now and carry on.

“Many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think,” he wrote. “We have to deal with the possibility that, at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate.”

Okay let us break this down. Firstly we are back to output gap theory again which of course has been wrong,wrong and wrong again in the credit crunch era. If there are signs of overheating then they are to be found in asset markets where we have seen booming bond prices and house prices and until recently all-time highs for equity markets. Only on Tuesday we looked at US house price growth of 6% or 7% depending which data you use.

Wages

I have picked this out because there has been quite a swerve from Jamie Dimon as for so long nearly everyone has been hoping for higher wages. Now suddenly apparently a rise is a bad thing? The Financial Times article implicitly parrots this line.

The prospect of an overheating economy has spooked the financial markets as recently as February, when stronger-than-expected US wage growth sparked the worst Wall Street sell-off in six years.

In terms of numbers a rise in average earnings growth per hour to 2.9% was hardly groundbreaking and of course it has since faded away showing the unreliable nature of one month’s data. In reality to return to old era trends we would need wages growth of 3.5%+ for a while. But in Jamie’s world that seems to be a bad thing although apparently not always. From Bloomberg.

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon received $29.5 million in total compensation for his work in 2017, an increase of 5.4 percent from a year earlier.

So we are left mulling a view where what was supposed to be good would now be bad! Although those of you who in the comments section have argued we will not see major interest-rate rises until wage rises for the ordinary person picks up are permitted a wry smile at this point.

What is expected?

From the FT article.

Prices of Fed funds futures suggest few expect the Fed to raise rates by more than three times this year, as policymakers have indicated. Longer-term market measures also indicate that investors expect inflation and bond yields to remain subdued for years to come.

I put the second sentence in because it is positively misleading. What those measures are provide a balancing of markets now and usually have very little to do with what will happen. Returning to interest-rates we got a view this week from former Federal Reserve Chair Janet Yellen.

At Monday’s larger forum for Jefferies clients, she expressed the view that three or four rate rises were likely this year, and that recent U.S. tax cuts and a boost in government spending posed at least some risk of running the economy hot, according to the first source, who requested anonymity. ( CNBC)

This is the awkward bit about the Jamie Dimon claim which is that the existing and likely moves in US interest-rates are a response to expected higher inflation anyway as of course as we have looked at many times it is still below the target. Back to Janet.

Later, over dinner at the Manhattan penthouse of Jefferies’ chief executive, Yellen told executives from hedge funds, private equity firms and other companies that she considered inflation to be in check and unlikely to spike, so rates would stay relatively low, according to a second person familiar with the discussion.

Take that as you will as of course we discovered in her time that she does not really understand inflation.

The Bank of England

So how will it respond as traditionally it follows the US Federal Reserve?

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Oh sorry not that one. Let us move onto its favourite publication the Financial Times.

Policymakers at the Bank of England are debating whether to be more forthcoming about their future plans for interest rates, as they gear up for a crunch vote on the cost of borrowing next month.

This is fascinating stuff because it both implies and suggests they know what their forecasts are! Let me give you an example reviewed favourably by Chris Giles the economics editor of the FT.

But last month Gertjan Vlieghe, an external MPC member, broke ranks with his colleagues on the nine-member committee when he said that rates could rise above 2 per cent over the same period.

Actually if we remove the rose-tintin ( sorry but he is Belgian) he seems an excitable chap as this from the Evening Standard in April 2016 reveals.

Vlieghe’s answer is intriguing: “Theoretically, I think interest rates could go a little bit negative.”

The long discussion on negative interest-rates that took place was clearly a hint of expected policy and means that Gertjan was wrong which poses a question over why we should listen this time? Although Chris Giles has a very different view.

Not sure it matters if people believe them.

I think it matters a lot. Oh and as the Swedish Riksbank has found it.

The Riksbank has had some difficulties with its predictions.

But to be fair Chris Giles does have a sense of humour ( I think).

But there remains concern that the BoE could undermine trust in it as an institution running an important public policy if it makes predictions about interest rates that do not come to pass.

Comment

Let me open with a rather good reply to this from GreaterFool.

Any shreds of credibility that the BoE once had disappeared into smoke after the forward guidance experiment. Telling people that you’ll raise rates after unemployment falls below 7% and then dropping them again when unemployment is below 5% will do that.

In fact the hits keep coming as though in this instance from Felix2012

There are quite a few commenters here who still take MPC seriously, unfortunately.

As to clarity well we did get that from Governor Carney back in June 2014.

There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced….“It could happen sooner than markets currently expect.

That was taken as a clear signal back then and the next day saw a lot of market adjustments which later led to losses as it never happened. Of course the road to a Bank Rate cut after Governor Carney hinted at it was both real and fast as we discovered 3 years later.

So what can we expect? The Bank of England has rather committed itself to a May Bank Rate rise which if you look at falling inflation and some weaker economic news looks out of touch. We have seen signs of slowing in Europe too as German industrial production has shown already today. The US Federal Reserve will no doubt carry on course unless there is a shock stateside although not everyone even thinks we need any tightening. BoI is the Bank of Italy.

 

What is happening to US house prices?

If you are a believer that the extraordinarily stimulatory monetary policies of the credit crunch era have boosted house prices via their impact on asset prices then the United States currently provides food for thought. This is because of this.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/2 to 1-3/4 percent.

For younger readers the US Federal Reserve has raised official interest-rates to extraordinary heights and for older ones it has barely got into the foothills. Either way The Fed-Home as Google now describes us thinks this.

 The stance of monetary policy remains accommodative,

In addition to the series of increases in interest-rates we have seen and continue to expect we are now in what I guess we need to call the QT or Quantitative Tightening era or as Marketwatch described it last month.

Last fall, the Fed announced plans to slowly reduce its balance sheet on auto-pilot, allowing holdings to shrink by $20 billion each month this quarter and moving up to a maximum of $50 billion per month by the end of the year.

From the peak of US $4.5 trillion the balance sheet has shrunk from US $4.5 trillion at its peak to US $.4.4 trillion as of the latest update. So QT has had an impact in terms of a small flow reduction which has led to a small stock reduction. Thus we have gone from small up to small down if we look at it like that although of course in other terms US $100 billion or so was a lot of money.

If we look ahead then Marketwatch point out that we were given a hint of a possible future late last year.

The Fed has not announced how low it wants to shrink its balance sheet. New Fed Chairman Jerome Powell discussed a target range of $2.5 trillion to $2.9 trillion in his confirmation hearing last fall.

Okay what does this impact?

A central bankers heart will gladden when they see these numbers from Money Magnify.

In the second quarter of 2017, real estate values in the United States surpassed their pre- housing crisis levels. The total value of real estate owned by individuals in the United States is $24 trillion, and total mortgages clock in at $9.9 trillion. This means that Americans have $13.9 trillion in homeowners equity.12 This is the highest value of home equity Americans have ever seen.

As they do not let me point out that such value calculations have the flaw of using a marginal price for an average concept which looks great when prices rise but not to great when they fall. If we move on we also see a consequence of the credit crunch era.

Current homeowners have mortgage payments that make up an average of just 16.5% of their annual household income.

That will be changing but not in the way that you think as the US market is mostly one of fixed-rate mortgages. So whilst both the policy changes above may affect it we see that over time QT is likely to have the largest impact. This is because the main player is the 30 year fixed rate mortgage which means that the 30 year Treasury yield is more of a factor that short-term interest-rates. When you look at what it has done you see that in a broad sweep the US Fed helped reduce it by around 1% from 2013 to late 2016 and it then rose by 1% to the current 4.44%. Actually if you look at the chart it is hard not to have a wry smile as for all the rhetoric and talk about QT the main player seems to have been the Donald as most of the rise was around the election of President Trump. Humbling for central bankers and their dreams of ruling the world! If you want to know how this took place I looked at it on the 9th of November 2016.

Before I depart the economic situation let me point out that we may well end up discussing as so often two different markets.

Today, half of all borrowers put down 5% or less. More than 10% of borrowers put 0% down. As a result, the average loan-to-value ratio at origination has climbed to 87%

Manhattan

Is this a case of a perfect storm? We have the effect of the factors above although of course they affect the 0.1% much less than the rest of us. But the winds of change as we have seen in central London have been blowing against capital city ( in which category New York is unofficially if not officially) property prices after many years of plenty. Also there has been this according to the Financial Times.

Some buyers held off buying real estate as they grappled with the impact of President Donald Trump’s changes to the federal tax code, which introduced a cap on the deduction of state and local taxes, including property taxes, from federal tax bills. It also reduced the size of mortgages eligible for interest deductions. The change is expected to hit high earners in high-tax states including New York, particularly in New York City.

This has led to this.

The number of co-op and condominium sales in Manhattan fell nearly 25 per cent during the first quarter compared to the same period last year………..It was the largest annual decline in sales in nine years, according to the report.

Okay so what about prices?

The average sale price across Manhattan fell by 8.1 per cent from the year-earlier quarter, and the average price per square foot also recorded a sharp decline, falling by 18.5 per cent to $1,697.

Perhaps fearing a lack of sympathy amongst even its readers the FT takes its time to point out what this means.

The average sales price of a luxury apartment fell 15.1 per cent, down from $9.36m in the first quarter of 2017 to $7.94m in the first quarter of this year, and the number of sales was down 24.1 per cent. The number of newly built apartments that went into contract fell 54 per cent.

As to lack of sympathy that was at play in the comments.

So now the average luxury apartment in Manhattan costs only $8 million? Not yet a bargain then? ( Genghis)

As was some perspective.

1600 usd per sqf for prime ? Still a bargain compared to London (JP1)……..I know. And positively a steal compared to Hong Kong !! (observer).

Looking wider

You might from the above expect lower prices but in fact at the end of last week we were told this. From Zillow Research.

The continuing inventory pinch helped boost the U.S. national Case Shiller index 6.2 percent in January from a year earlier, down from a 6.3 percent gain in December. Case-Shiller’s 10-City Composite rose 6 percent, while the 20-City Composite climbed 6.4 percent year-over-year.

Some places are in fact red hot.

Home prices in Seattle, Las Vegas, and San Francisco posted the highest annual gains among the 20 cities, rising 12.9 percent, 11.1 percent and 10.2 percent, respectively.

Zillow remain of the view that house prices will continue to rise as I note that rather like us in the UK there is a perception that too few houses have and indeed are being built. For perspective I note that a different piece of research tells us this.

Home values rose 7.6 percent year-over-year to a median of $210,200, with the San Jose, Calif., metro posting astonishing annual home value growth of 26.4 percent, reaching a median of $1.25 million.

Comment

We find ourselves reflecting on the words of Glenn Frey again.

The heat is on

Except not in the way that economics 101 would have predicted as we continue to see house price rises if we ignore the “international effect”. According to the Brookings Institute there may be a deeper factor as human behaviour returns to what it was.

The Census Bureau’s annual county and metropolitan area estimates through 2017 reveal a revival of suburbanization and movement to rural areas along with Snow Belt-to-Sun Belt population shifts. In addition, the data show a new dispersal to large- and moderate-sized metro areas in the middle of the country—especially in the Northeast and Midwest. If these shifts continue, they could call into question the sharp clustering of the nation’s population—in large metropolitan areas and their cities—that characterized the first half of the 2010s.

So the suburbs are back in favour so let me leave you with the thoughts of Arcade Fire on the subject.

And all of the walls that they built in the seventies finally fall
And all of the houses they built in the seventies finally fall

Maybe they got onto the consumer society as well in a different song.

(Everything now!) I need it
(Everything now!) I want it
(Everything now!) I can’t live without
(Everything now!) I can’t live without
(Everything now!) I can’t live
(Everything now!)

Is the US economy at a turning point?

Yesterday brought us some significant news from the US economy. One segment of this was the testimony given by the new Chair of the US Federal Reserve Jerome Powell as everyone combs his words looking for any signs of a change in policy. The sentence from the written testimony that has drawn most attention is below.

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis. ( PCE is Personal Consumption Expenditure )

The reason for that is the use of the word “overheated” which brings with it all sorts of value judgements and implications. This was added to by the phrase he added to this.

My personal outlook for the economy has strengthened since December.

We also got an explanation of what was driving such thoughts.

 In particular, fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory. Despite the recent volatility, financial conditions remain accommodative.

The nod to fiscal policy was a change of emphasis from his predecessor Janet Yellen as I am reminded of the analysis of the US Congress on the subject we looked at on February the 8th.

The Joint Committee staff estimates that this proposal would increase the average level of output (as measured by Gross Domestic Product (“GDP”) by about 0.7 percent relative to average level of output in the present law baseline over the 10-year budget window.

The underlying position

The thoughts above added to the existing situation which Chair Powell described thus.

Turning from the labor market to production, inflation-adjusted gross domestic product rose at an annual rate of about 3 percent in the second half of 2017, 1 percentage point faster than its pace in the first half of the year.

So the fiscal policy will add to an already strengthening situation and the emphasis is mine.

Economic growth in the second half was led by solid gains in consumer spending, supported by rising household incomes and wealth, and upbeat sentiment. In addition, growth in business investment stepped up sharply last year, which should support higher productivity growth in time.

The reason I have highlighted that bit is because Chair Powell had explicitly linked it to wage growth.

Wages have continued to grow moderately, with a modest acceleration in some measures, although the extent of the pickup likely has been damped in part by the weak pace of productivity growth in recent years.

If we switch to the section on employment we see a continuing theme.

Monthly job gains averaged 179,000 from July through December, and payrolls rose an additional 200,000 in January. This pace of job growth was sufficient to push the unemployment rate down to 4.1 percent, about 3/4 percentage point lower than a year earlier and the lowest level since December 2000.

Are we seeing a hint of Phillips Curve style analysis which would predict wage growth acceleration? We did get told he likes policy rules.

Personally, I find these rule prescriptions helpful

Also you may note that he hinted at a pick-up in jobs growth in January which comes when the unemployment rate tells us that according to old policy rules we have what would have been considered to be full employment. It was also interesting that he skirted what we might call the missing eleven million or so via the drop in the participation rate.

the labor force participation rate remained roughly unchanged, on net, as it has for the past several years

I am not sure that it all be blamed on retiring “baby boomers” as we were told.

So we are told that the economy is strong and got a pretty strong hint that higher wage growth is expected and of course that follows the 2.9% growth seen in January in average hourly earnings.

Wages should increase at a faster pace as well.

What about inflation?

That is supposed to pick-up as well as we continue our journey on a type of virtual Phillips Curve.

 we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term.

These days it is something of a residual item in speeches by central bankers. This is for two main reasons. The first is that they have really been targeting output and the labour market. The second is that even after an extraordinary amount of QE they failed to generate the ( consumer) inflation they promised and so they are de-emphasising it.

Overheating?

This subject flickered onto some radar screens yesterday as they observed this from the Census Bureau.

The international trade deficit was $74.4 billion in January, up $2.1 billion from $72.3 billion in December.
Exports of goods for January were $133.9 billion, $3.1 billion less than December exports. Imports of goods
for January were $208.3 billion, $0.9 billion less than December imports.

This is something which has been rising as we note this from the Bureau of Economic Analysis or BEA earlier this month.

For 2017, the goods and services deficit increased $61.2 billion, or 12.1 percent, from 2016. Exports
increased $121.2 billion or 5.5 percent. Imports increased $182.5 billion or 6.7 percent.

So we may well be seeing economic growth sucking in imports yet again or a different form of overheating. Thus the words of Chairman Powell above on exports were both true ( they are up) and to some extent misleading as imports have risen faster. This is reinforced with my usual caution about monthly trade data by  the size of the January  goods deficit which is the largest for ten years. If we allow for the fact that the shale oil and gas boom flatters the figures the numbers take a further turn for the worse.

Consumer Confidence

We return to the same theme as we note this.

The Conference Board Consumer Confidence Index® increased in February, following a modest increase in January. The Index now stands at 130.8 (1985=100), up from 124.3 in January. The Present Situation Index increased from 154.7 to 162.4, while the Expectations Index improved from 104.0 last month to 109.7 this month.

So another signal looks strong.

Comment

If we start with the analysis of Chair Powell we see that the US Federal Reserve plans to continue interest-rate rises this year and that it means to do so either 3 or more likely 4 times. This is based on the view that otherwise the economy will overheat as discussed above. Let me add a personal view to this which is the current madness of going along at 0.25%, why not raise by 0.5% in March and then sit back for a while and see what develops? Monetary policy has long lags and if you take ages to act you are at an ever greater risk of being proved wrong.

Another factor in this is the data I have looked at above as I have held something back until now which is troubling. Here is the extra bit from the consumer confidence figures.

Consumer confidence improved to its highest level since 2000 (Nov. 2000, 132.6).

Now if we look at the trade in goods figures the deficit was last higher in January 2008 a time when consumer confidence was high in many places too. What happened next in both instances?

If we continue with that line of thought we find that the oil market may be giving a hint as well.

https://twitter.com/a_coops1/status/968783142717919233

Another reason I think to act more decisively now as after all interest-rates will only be 1.75% to 2% after a 0.5% rise a level I have long argued for and then wait and see. After all we could be seeing a flicker of a road to QE4.

What is happening with fiscal policy?

A feature of the credit crunch era has been the way that monetary policy has taken so much of the strain of the active response. I say active because there was a passive fiscal response as deficits soared caused on one side by lower tax revenues as recession hit and on the other by higher social payments and bank bailout costs. Once this was over the general response was what has been badged as austerity where governments raised taxes and cut spending to reduce fiscal deficits. Some care is needed with this as the language has shifted and often ignores the fact that there was a stimulus via ongoing deficits albeit smaller ones.

Cheap debt

Something then happened which manages to be both an intended and unintended consequence. What I mean by that is that the continued expansion of monetary policy via interest-rate reductions and bond buying or QE was something which governments were happy to sign off because it was likely to make funding their spending promises less expensive. Just for clarity national treasuries need to approve QE type policies because of the large financial risk. But I do not think that it was appreciated what would happen next in the way that bond yields dropped like a stone. So much so that whilst many countries were able to issue debt at historically low-levels some were in fact paid to issue debt as we entered an era of negative interest-rate.

This era peaked with around US $13 trillion of negative yielding bonds around the world with particular areas of negativity if I may put it like that to be found in Germany and Switzerland. At one point it looked like every Swiss sovereign bond might have a negative yield. So what did they do with it?

Germany

This morning has brought us solid economic growth data out of Germany with its economy growing by 0.6% in the last quarter of 2017. But it has also brought us this.

Net lending of general government amounted to 36.6 billion euros in 2017 according to updated results of the Federal Statistical Office (Destatis). In absolute terms, this was the highest surplus achieved by general government since German reunification. When measured as a percentage of gross domestic product at current prices (3,263.4 billion euros), the surplus ratio of general government was +1.1%.

So Germany chose to take advantage of being paid to issue debt to bring its public finances into surplus which might be considered a very Germanic thing to do. There is of course effects from one to the other because their economic behaviour is one of the reasons why their bonds saw so much demand.

But one day they may regret not taking more advantage of an extraordinary opportunity which was to be able to be paid to borrow. There must be worthy projects in Germany that could have used the cash. Also one of the key arguments of the credit crunch was that surplus countries like Germany needed to trim them whereas we see it running a budget surplus and ever larger trade surpluses.

In the detail there is a section which we might highlight as “Thanks Mario”

 Due to the continuing very low-interest rates and lower debt, interest payments decreased again (–6.4%).

Switzerland

The Swiss situation has been similar but more extreme. Membership of the Euro protected Germany to some extent as the Swiss Franc soared leading to an interest-rate of -0.75% and “unlimited” – for a time anyway – currency intervention. This led to the Swiss National Bank becoming an international hedge fund as it bought equities with its new foreign currency reserves and Switzerland becoming a country that was paid to borrow. What did it do with it? From its Finance Ministry.

A deficit of approximately 13 million is expected in the ordinary budget for 2018.

So fiscal neutrality in all but name and the national debt will decline.

 It is expected that gross debt will post a year-on-year decline of 3.3 billion to 100.8 billion in 2018 (estimate for 2017). This reduction will be driven primarily by the redemption of a 6.8 billion bond maturing combined with a low-level of new issues of only 4 billion.

The UK

Briefly even the UK had some negative yielding Gilts ( bonds) in what was for those who have followed it quite a change on the days of say 15% long yields. This was caused by Mark Carney instructing the Bank of England’s bond buyers to rush like headless chickens into the market to spend his £60 billion of QE and make all-time highs for prices as existing Gilt owners saw a free lunch arriving. Perhaps the Governor’s legacy will be to have set records for the Gilt market that generations to come will marvel at.

Yet the path of fiscal policy changed little as indicated by this.

Or at least it would do if something like “on an annual basis” was added. Oh and to complete the problems we are still borrowing which increases the burden on future generations. The advice should be do not get a job involving numbers! Which of course are likely to be in short supply at a treasury………..

But the principle reinforces this from our public finances report on Wednesday.

Public sector net borrowing (excluding public sector banks) decreased by £7.2 billion to £37.7 billion in the current financial year-to-date (April 2017 to January 2018), compared with the same period in the previous financial year; this is the lowest year-to-date net borrowing since the financial year-to-date ending January 2008.

So we too have pretty much turned our blind eye to a period where we could have borrowed very cheaply. If there was a change in UK fiscal policy it was around 2012 which preceded the main yield falls.

Bond yields

There have been one or two false dawns on this front, partly at least created by the enthusiasm of the Bank of Japan and ECB to in bond-buying terms sing along with the Kaiser Chiefs.

Knock me down I’ll get right back up again
I’ll come back stronger than a powered up Pac-Man

This may not be entirely over as this suggests.

“Under the BOJ law, the finance ministry holds jurisdiction over currency policy. But I hope Kuroda would consider having the BOJ buy foreign bonds,” Koichi Hamada, an emeritus professor of economics at Yale University, told Reuters in an interview on Thursday.

However we have heard this before and unless they act on it rises in US interest-rates are feeding albeit slowly into bond yields. This has been symbolised this week by the attention on the US ten-year yield approaching 3% although typically it has dipped away to 2.9% as the attention peaked. But the underlying trend has been for rises even in places like Germany.

Comment

Will we one day regret a once in a lifetime opportunity to borrow to invest? This is a complex issue as there is a problem with giving politicians money to spend which was highlighted in Japan as “pork barrel politics” during the first term of Prime Minister Abe. In the UK it is highlighted by the frankly woeful state of our efforts on the infrastructure front. We are spending a lot of money for very few people to be able to travel North by train, £7 billion or so on Smart Meters to achieve what exactly? That is before we get to the Hinkley Point nuclear power plans that seem to only achieve an extraordinarily high price for the electricity.

One example of fiscal pump priming is currently coming from the US where Donald Trump seems to be applying a similar business model to that he has used personally. Or the early days of Abenomics. Next comes the issue of monetary policy where we could of course in the future see news waves of QE style bond buying to drive yields lower but as so much has been bought has limits. This in a way is highlighted by the Japanese proposal to buy foreign bonds which will have as one of its triggers the way that the number of Japanese ones available is shrinking.

Could US fiscal expansionism lead us to QE4?

The credit crunch era has been one where monetary policy has taken centre stage. There are many ways of expressing this but one is that technocrats ( central bankers) have mostly run the economic show as elected politicians have chosen to retreat to the sidelines as much as possible. Whatever you may think of President Trump he is not someone who is happy to be on the sidelines as he has exhibited publicly once or twice with some pushing and shoving. But more importantly we are seeing something of a shift in the balance of US economic policy as the monetary weapon gets put away at least to some extent but the fiscal one seems to be undergoing a revival.

A relatively small reflection of this was last night’s budget deal. We have become used to talk of a US government shutdown followed by an eleventh hour deal and no doubt there is a fair bit of both ennui and cynicism about the process. But as the Washington Post notes as we as giving the national debt can another kick there was this in the detail.

According to outlines of the budget plan circulated by congressional aides, existing spending caps would be raised by a combined $296 billion through 2019. The agreement includes an additional $160 billion in uncapped funding for overseas military and State Department operations, and about $90 billion more would be spent on disaster aid for victims of recent hurricanes and wildfires.

An increase in military spending was a Trump campaign promise so it is no surprise but spending increases come on top of the tax cuts we saw at the end of last year.

The Trump Tax Changes

According to the US Committee for a Responsible Fiscal Budget there was much to consider.

The final conference committee agreement of the Tax Cuts and Jobs Act (TCJA) would cost $1.46 trillion under conventional scoring and over $1 trillion on a dynamic basis over ten years, leading debt to rise to between 95 percent and 98 percent of Gross Domestic Product (GDP) by 2027 (compared to 91 percent under current law). However, the bill also includes a number of expirations and long-delayed tax hikes meant to reduce the official cost of the bill. These expirations and delays hide $570 billion to $725 billion of potential further costs, which could ultimately increase the cost of the bill to $2.0 trillion to$2.2 trillion (before interest) on a conventional basis or roughly $1.5 trillion to $1.7 trillion on a dynamic basis over a decade. As a result, debt would rise to between 98 percent and 100 percent of GDP by 2027.

This is a familiar political tactic the world over where the numbers depend on others taking the difficult decisions in the future! One rather sneaky move is the replacement in terms of income tax thresholds of inflation indexation by the US Consumer Price Index by the chained version which is usually lower. So jam today but more like dry toast tomorrow.

Won’t this boost the economy?

There are enough problems simply doing the direct mathematics of government spending and revenue but the next factor is how do they effect the economy? Well the US Congress has given it a go.

The Joint Committee staff estimates that this proposal would increase the average level of output (as measured by Gross Domestic Product (“GDP”) by about 0.7 percent relative to average level of output in the present law baseline over the 10-year budget window. That
increase in output would increase revenues, relative to the conventional estimate of a loss of $1,456 billion over that period by about $451 billion. This budget effect would be partially offset by an increase in interest payments on the Federal debt of about $66 billion over the budget
period.

The idea of tax cuts boosting the economy is a reasonable one but the idea you can measure it to around US $451 billion is pure fantasy. To be fair they say “about” but it should really be if you will forgive the capitals and emphasis “ABOUT“. Anyway for the moment let us move on noting that there is already a fair bit of doubt about the impact on the US deficit over time from US $1 trillion or so to a bit over US $2 trillion.

What is the deficit doing?

According to the US CBO ( Congressional Budget Office) it has been rising anyway in the Trump era.

The federal budget deficit was $174 billion for the first four months of fiscal year 2018, the Congressional
Budget Office estimates, $16 billion more than the shortfall recorded during the same period last year.
Revenues and outlays were higher, by 4 percent and 5 percent, respectively, than during the first four
months of fiscal year 2017.

As you can see revenues are doing pretty well and in fact are being led by taxes on income being up by 8%. However spending rose even faster at an annual rate of 5% which at a time of economic growth gives us food for thought. There was one curious detail and one familiar one in this.

Social Security benefits rose by $11 billion (or 4 percent) because of increases both in the number of beneficiaries and in the average benefit payment.

That seems odd at a time of economic growth but the next bit reminds us that the rise in inflation has a cost too due to index-linked bonds called TIPS.

Outlays for net interest on the public debt increased by $13 billion (or 14 percent), largely because of differences in the rate of inflation.

More Spending?

It looks as though we will find out more about the much promised infrastructure plan next week. From Bloomberg.

President Donald Trump expects to release on Monday his long-awaited plan to generate at least $1.5 trillion to upgrade U.S. roads, bridges, airports and other public works, according to a White House official.

How much of this will come from the government is open to debate. The modern methodology is to promise some spending ( in this case US $200 billion) and assume that the private-sector will do the rest. One of the more extraordinary efforts on this front was the Juncker Plan in the Euro era which assumed a multiplier of up to twenty times. But returning stateside we can see that there will be upwards pressure on spending but so far we are not sure how much.

Comment

In my opening I suggested that the United States was switching from monetary expansionism to fiscal expansionism. Let me now introduce the elephant in this particular room.  From the Atlanta Fed

The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2018 is 4.0 percent on February 6, down from 5.4 percent on February 1.

They may well be somewhat excitable but if we look at the 3.2% predicted by the New York Fed the view is for pretty solid economic growth. So the fiscal position should be good especially if we add in the fact that for all the media hype treasury bond yields are historically still rather low. Yet none the less the fiscal pump is being primed. Or to put it more strictly after a period of pro-cyclical monetary policy we now seem set for pro-cyclical fiscal policy.

There are obvious implications for the bond market here as there will be increases in supply on their way. No doubt for example this has been a factor in pushing the thirty-year bond yield above 3%. You might have expected more of an impact but I am increasingly wondering about something I suggested some time ago that the path to higher interest-rates in the United States might be accompanied by QE4 or a return to bond buying by the US Federal Reserve. Should the economy slow at any point which would boost the deficit on its own then we could see it. Also this could be a factor in the weaker US Dollar as in is it falling to reflect the risks of a possible return to Quantitative Easing?

The deep question here is can we even get by these days without another shot of stimulus be it monetary,fiscal or both?

Me on Core Finance TV

 

 

 

What are the consequences of rising bond yields?

So far in 2018 we have seen a move towards higher bond yields across the financial world. This poses more than a few questions not least for the central banks who went to unparalleled efforts in terms of scale to try to reduce them. This as I pointed out on the 6th of December led to some changes.

The credit crunch era has brought bond markets towards the centre stage of economics and finance. Before then there were rare expressions of interest in either a crisis or if the media wanted to film a response to an economic data release. You see equities trade rarely but bonds a lot so they filmed us instead and claimed we were equities trades so sorry for my part in any deception!

At the moment they are back in the news and this morning the Bank of Japan responded. From the Wall Street Journal.

The Bank of Japan took on the market and won—for now.

As Japanese 10-year bond yields threatened to break through the 0.1% mark early Friday, the bank threw down the gantlet and offered to buy out every player in the market.

If we step back for a moment it is hard not to have a wry smile at the Bank of Japan defending a yield on a mere 0.1%!  Not much of a yield or a bear market is it? It poses the question of how strong the economic recovery might be if that is all we can take. Overall it is a consequence of this.

“Today’s action was aimed at firmly implementing the bank’s policy target of guiding the 10-year yield around zero, taking into consideration recent large increases in long-term yields,” a senior BOJ official said. For the BOJ, “around zero” essentially means up to but not including 0.1%.

I am not so sure about the “large increases in long-term yields” story as in fact the thirty and forty-year yields have been dropping. But the response was as follows.

The bank offered to buy an unlimited amount of JGBs with remaining maturities of five to 10 years at a fixed rate of 0.11%, the same level it used on two previous occasions. Yields slipped to 0.85% from 0.95%.

This poses a couple of questions. Firstly for the argument that the Bank of Japan is tapering its bond buying or QE ( which is called QQE in Japan) as offering to buy an “unlimited amount” is hardly tapering. The issue here you may note is rather like that of the Swiss National Bank defending the Swiss Franc at 1.20 which suddenly found it was intervening on an enormous scale. So what looks like tapering could morph into expansion quite easily. How very Japanese!

Also I guess if you own 40% or so of a market as the Bank of Japan does you too would be touchy and nervous about any rise in yield and fall in prices. Time for En Vogue on its tannoy loudspeakers.

Hold me tight and don’t let go
Don’t let go
You have the right to lose control
Don’t let go

Maybe our songstresses even had a view for us on how likely it is that the central banking control freaks will reverse course.

I know you think that if we move too soon it would all end

The UK

This is an intriguing one as you see the ten-year Gilt yield has risen to 1.58% this morning  Here is how Bloomberg reflects on this.

Ten-year gilt yields climbed five basis points to 1.58 percent as of 9:29 a.m. London time, after touching 1.59 percent, their highest level since May 2016. The yield has surged about 40 basis points this year.

This is considered a bear market which as someone who has definitely seen such moves in a day and maybe when we were ejected from the ERM in 1992 maybe an hour is hard to take. So let us settle on a QE era bear market. Also the QE link comes back in as the high for UK Gilts was driven by the panic buys of late summer 2016 when the Bank of England dove into the market like a kamikaze pushing the yield down to 0.5%. From time to time apologists for such moves claim that QE does not make losses but if you pay 120 for something and get back 100 at maturity what is that please?

Intriguingly at least one player may have been wondering about a real bear market. From James Mackintosh in the WSJ.

The trade goes like this: borrow £750 million ($1 billion) for 100 years at a time when money is basically free. Invest it in shares. Pocket the difference.

Okay perhaps not a real bear market as that would affect shares too and as you see below the money is cheap in historical terms but not free.

 The scale of that demand was shown Wednesday when Wellcome’s 100-year bond was more than four times oversubscribed with a coupon of just 2.517%, the lowest ever paid on a corporate century bond.

That is not likely to be much in real yield terms and I would much rather be Welcome that those who bought the bonds. They think along the lines I pointed out in my post on Monday on pensions and the distorted world there.

Wellcome Chief Investment Officer Nick Moakes says ultralong bonds are distorted by rules forcing insurance companies and pension funds to buy them at any price, creating an uneconomic demand he is happy to satisfy with a bond issue

Of course buying equities at what is something of a top after a succession of all-time highs might be a case of not the best timing.

The US

This is the leader of the pack on such matters on two counts. It is the world’s largest economy and it currently has a central bank which is in the process of raising interest-rates. It’s central bank is even reducing its stock of bonds albeit at a snail’s pace. If we stick with the domestic impact then it is led by the thirty-year yield which has nudged over 3%. This means that the thirty-year fixed mortgage rate is now 4.23% as we look for the clearest link between the financial world and the real economy.

If we look at the shorter end of the scale we see that the rate rises so far combined with the expectations of more have seen the two-year yield rise to 2.16% as opposed to the 1.2% of this time last year. So there has been a tightening of monetary conditions all round from this route.

Comment

There is a lot to consider here and let us start with the economics. A rise in bond yields tightens monetary conditions and in that sense is a logical response to the better economic environment. However it is awkward for central banks who have paid more than the 100 they will get from their treasury on maturity as politicians have got used to spending the explicit and implicit profits. If they sell their holdings then they will exacerbate the price falls and weaken their remaining stock.

Moving to the foreign exchanges we have seen something rather odd. If you buy the US Dollar you get 2.8% right now if you put the money in a ten-year US Treasury Note whereas if you buy the Japanese Yen you only get 0.9%. So the US Dollar is rising right? Eh no, as I have covered many times. Of course some may be buying now thinking that an US Dollar in the 109s is attractive combined with picking up a 2.7% relative yield. Similar arguments can be made for the Euro and UK Pound £ albeit with smaller yield differentials.

Here is another thought for you. Imagine a Swiss or German version of Wellcome if there is one and how cheaply they could borrow for 100 years. Actually with its international position it could presumably have borrowed in Euros. Perhaps it is bullish of the UK Pound £……..brave if you look back 100 years.

Meanwhile if the bond bear market and its consequences are all too much there is apparently something which can take the pain away.