Three seminal issues have driven the recovery of the past two years: government rescue money, bank stress tests, and exceptionally low interest rates – all products of government intervention. The government included the kitchen sink in its response. In reaction, Americans are expressing disappointment that the real recovery is not further along given all of the suffering and stimulus. Frustration is being directed at the government, but the frustration, in our opinion, better illustrates the depth of the problems. In any event, the magnitude of the government response has longer term implications apart from the massive federal budget deficits. These side effects of intervention are what keep us cautious for now.
Money was the first and strongest response by our government to the current financial crisis – money and government guarantees of money. The federal government backed money market accounts, certificates of deposit, mortgage-backed bonds, and banks’ overnight liquidity, and put Freddie Mac and Fannie Mae into receivorship, to name just a very few. Dallas Federal Reserve Bank President Richard Fisher said recently that the Fed had “done quite enough” in the supply of rescue and stimulus dollars. He suggested that the failure of the policy response was due to the uncertainty created by legislators in Washington. Policy uncertainty is a constant risk. That so much has been enacted, and is in the process of being enacted, has many waiting on the sidelines trying to suss out the new landscape. In other words, the uncertainty created by the government’s response to the crisis is at least partially responsible for the delays in recovery. Ironic, huh?
Markets began to rally as Bank Stress Tests were proposed. An imploding banking system always comes down to the same thing: confidence. Alexander Hamilton wrote about the necessity of having the public’s faith and confidence as essential to a successful banking system. Bank Stress tests were designed by the Federal Reserve, though they wouldn’t share the findings at first. The Fed, after a reasonable period, declared the majority of major banks as sound, and investors and depositors alike accepted their word. Markets rallied. However, the banks have not been purged of their troubled assets. Rather, the increased accounting flexibility permitted by the government has perpetuated the lack of confidence in the banks’ financial condition. And bank management teams don’t want to lend if they don’t know how bad the losses on their legacy loans will get. Moreover, the unwillingness to lend is exacerbated by the uncertainty surrounding future capital requirements and other regulatory constraints. Is it any wonder why bank balance sheets are contracting with every passing quarter?
Interest rates are low and have been low thanks to a low Fed Funds rate and the Fed’s quantitative easing. The Federal Reserve has even given up on tightening threats. The strongest statement we heard recently was that a certain Fed governor was growing less comfortable with the “extended period” language. Low interest rates have meant low mortgage rates, and low mortgage rates have offered support for home prices. But rates alone weren’t enough: in the first quarter of 2010, the government funded 96.5% of all new mortgages in the US. Apart from mortgages, low interest rates keep payments on all types of consumer debt in check. Higher debt service costs would add additional pressure to businesses and consumers and therefore curtail spending. Moreover, higher interest rates would lead to a surge in the federal government’s debt service costs. Therefore, from this perspective, we have been fortunate that the European debt crisis has led to a “flight to quality” in Treasury bonds. However, the resulting low rates have effectively “reset” the economy to unsustainably low interest rates. We are concerned what happens when the music stops.
We know that we can’t precisely forecast interest rates. There is historic precedent for long-term interest rates remaining very low for years after a country begins to de-leverage as the U.S. economy began to do in 2008. On the other hand, the Federal Reserve is terrified of deflation and appears willing to avoid deflation at nearly all costs. This would suggest that inflation will eventually be the greater problem. Therefore, buying high quality, intermediate term bonds seems most prudent at this time. Keeping bond portfolios too short is risky if rates stay low longer than the consensus expects. Keeping them too short also causes clients to miss out on the steep yield curve. Conversely, investors buying primarily long-term bonds are at risk in a rising interest rate environment. Inflation kills long-term bond returns. The middle road seems most appropriate. Reasonable opportunities exist in high-quality corporate bonds, taxable municipal bonds, agency bonds, and tax-exempt municipal bonds.
As for stocks, it makes sense to maintain a defensive posture as we wait and see what the world looks like when the government takes away the training wheels. The economy is now, perhaps more than any time in recent history, dependent on low interest rates to drive economic activity and asset prices higher. As the government reduces its presence in the private sector, it remains unclear what will happen. Can we reasonably expect mortgage rates to stay this low if the government is not providing guarantees and purchasing large quantities of mortgage-backed securities? Will Treasuries be in such high demand once the European crisis passes? We are not saying that the economy undoubtedly cannot withstand modestly higher long-term interest rates. However, at the very least, higher interest rates may place a ceiling on the voracity of any economic recovery. Given this, it is hard for us to get too excited about the near term outlook for the economy.