Playing with Fire

There is ample discussion about the possible damage that may ensue as a result of the federal government’s inability to agree on budgets and debt ceiling increases. So far, the wrangling on Capitol Hill has contributed to some volatility in the capital markets but nothing as dire as the forecasts of some prognosticators. In fact, Treasury yields actually fell following a debt downgrade by Standard & Poors in August, 2011. While recognizing the rating agencies’ increasing impotence following the credit crisis, we suspect the major reason that calamity was avoided was there was no where else to go. For lack of better alternatives, money continued flowing into dollar-denominated assets – especially Treasuries.

But we won’t always be able to count on being the best house in a bad neighborhood. At some point, it is likely that the dollar begins to lose its status as the world’s primary reserve currency. According to a recent article in the New York Times by Eduardo Porter, “almost two-thirds of the world’s foreign currency reserves are held in dollar assets, mostly Treasury bonds.” Converting these assets into other currencies obviously would take a long, long time. However, the federal government continues to issue massive amounts of Treasuries each year as large budget deficits continue and expiring debt must be refinanced. Foreign central banks, tiring of our political brinksmanship, are increasingly talking about diversifying away from the US dollar. If the diversification initiatives accelerate, the increased costs of funding our government would just be the tip of the iceberg for the US economy.

This much is clear: Our economy remains heavily levered and overly dependent on artificially low interest rates. Interest rates remain historically low not only due to aggressive Fed monetary policy but also because of the dollar’s status as the world’s reserve currency. Foreign central banks simply have no better alternative than the dollar for their reserves right now, but that doesn’t mean this will always be true. If and when foreign banks begin to aggressively diversify away from dollar-denominated assets, the US government and Federal Reserve may not be able to rely on such low borrowing costs. Sure, if these changes happen over a very long period of time, they may be digestible. However, any sudden drop in appetite for US Treasury bonds could put the economy at big risk.

So what would be some of the repercussions of sharply higher Treasury rates?

  • First and most obvious, the costs of funding the government would increase. The $12 trillion+ in federal debt held by the public will have to be refinanced at some point, and higher interest rates would only worsen our long-term fiscal outlook.
  • Second, higher long-term interest rates would cause big losses on financial assets, including stocks and bonds of all stripes. Bond prices move inversely to interest rates, and all bond yields are priced off of “risk-free” Treasury rates. As for stocks, it should be no surprise that the stock market has surged in large part due to the Fed’s aggressive monetary easing (which has reduced interest rates to very low levels and forced investors into riskier assets). A sharp reversal in rates would undoubtedly cause some pain for stock investors.
  • Third, the recovery in housing prices has been heavily dependent on record-low mortgage rates. A sharp reversal in mortgage rates would undoubtedly slow housing turnover, housing price increases, and investments in home improvements.
  • Fourth, the consumer’s debt service burden would increase with higher interest rates. One of the oft-sited reasons for optimism about the economic recovery has been the drop in the consumer’s debt-service ratio (DSR). The drop was due largely to bad loans getting charged off at banks and the sharp drop in interest rates. A reversal in rates would eventually put a strain on consumer finances given the still-high level of consumer debt.
  • Finally, under a scenario of higher interest rates, the consumer’s willingness to borrow and spend would fall. We have long argued that the consumer is ill-prepared for retirement and must save more. (See my first book, A Million Is Not Enough.) While savings rates did increase in the wake of the financial crisis, they have begun to decrease again over the past couple of years. We would expect savings rates to reverse course again if interest rates suddenly increase.

The bottom line, in our view, is that the economy is not strong enough to support a significant increase in interest rates. As rates begin to rise in anticipation of Fed “tapering”, we would expect an eventual reversal as economic indicators begin to deteriorate. In other words, there is a ceiling on the pace of this economic recovery until deleveraging runs its course (which could be a long while).

As for a “Tapering Forecast,” it seems reasonable that a very modest decrease in the current monthly pace of $85 billion would send stock prices lower. But, given the large amount of liquidity in the system, we suspect that any downturn will be short-lived. If a transparent, well-articulated plan for lessening the current accommodation tour-de-Fed-force is matched against consistent economic improvements, this slow march to a recovered economy just might work. In the event that there are unpleasant and unforeseen problems, it remains important to be defensive and know what you own and why you own it.

We are grateful for all of our readers. We thank you for your comments, support, and friendship. Have your best Thanksgiving ever!