Yellen’s 2.25% Target for 2016 May Be a Huge Mistake
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Janet Yellen surprised almost everyone on March 19 by speaking off-script and providing forward policy guidance that can undermine the Fed’s credibility, at best, or cause another crisis, at worst. If the economic data comes in weak by the end of tapering and the markets swoon, the Fed will have no choice but to implicitly admit it was wrong and keep interest rates close to zero indefinitely. However, if the Fed continues with its plan to raise rates in the face of a weaker economy and declining market, the actions may cause another violent crash.
Zero short-term rates and the first round of QE were essential to avoid a complete financial meltdown. Subsequent rounds did little for the real economy yet unintentionally produced high leverage and asset bubbles in various places by providing cheap financing for companies, investors, and speculators alike. The policy also resulted in a massive transfer of wealth from labor to asset owners leading to the largest wealth and income inequality in recent history.
The 2.25% target for 2016 appears to ignore the serious consequences such a rate hike would have on the federal budget, company earnings, business default rates, financial leverage, and credit expansion. If combined together, such effects would be very serious.
- The federal budget. Higher rates would blow a hole in the federal budget by drastically increasing interest expenses. The government has great difficulty increasing its borrowing levels sufficiently just to service existing debt. Other expenditures (including tax breaks) might have to come down, putting pressure on the GDP growth and future government revenues.
Here is a “back of the envelope” calculation: Total federal government’s debt is currently $17.5 trillion. By 2016 that number would likely be around $19 trillion. In 2013, the government paid $416 billion in interest. Due to lower rates, this was less than $430 billion paid in 2007 when the total debt stood at only $9 trillion. Most of government debt is in short maturities. Therefore, a rise in rates would have a relatively quick and direct impact on interest payments. Assuming that rates rise across all maturities by 2%, the treasury debt service increases by about $380 billion annually. Total annual interest payments alone could approach the $1 trillion mark within a few years.
- Company earnings. Total revenues and earnings of nonfinancial companies have increased slowly since 2009. In part, earnings increases have been made possible by lower interest payments from refinancing existing debt. Companies have also increased their total debt using the cash proceeds to buy back stock. With fewer shares of stock outstanding, the same earnings produced lower P/E multiples, which attracted investors who saw growth in earnings per share and stocks that appeared cheap.
Furthermore, successive rounds of monetary stimulus reduced perceived risk (see “Bernanke put ”), lowered risk premiums and led to “P/E expansion” – in other words, higher stock prices for the same earnings.
Higher interest rates can put the whole process in reverse leading to lower absolute earnings, quickly rising P/E ratios and increases in risk premiums. The effect on stock market prices could be non-linear and abrupt due to a positive feedback loop, as it normally tends to happen.
- Default rates. Highly-levered companies using junk bonds for financing could start defaulting at the much higher rate, driving away liquidity and pushing rates even higher.
- Financial leverage. The level of margin debt in brokerage accounts and debt in various pooled investment vehicles has increased substantially since 2009. While on a relative basis to current asset values, leverage ratios do not appear to be outside of historical norms − should asset prices experience a significant correction − margin calls could add further selling pressure.
- Credit expansion. Since the velocity of money remains on a secular decline, nominal GDP growth could come from credit expansion, meaning: quantity of money (and debt). This would require one or more economic groups to borrow and spend. The 2001-2007 boom was driven primarily by individuals borrowing against residential real estate. From 2008 until now, the government acted as a “the borrower and spender of last resort” with some contribution from businesses. Going forward, we have to wonder if there is any economic group or entity left that would be both willing and able to borrow and spend commensurately. The only group with such an ability that comes to mind would be the “super-rich.” However, that leaves the question of willingness.
In conclusion, it appears that Fed’s policies and actions continue to contribute (or perhaps drive) booms and busts in asset prices. Yet, most investors have finally capitulated to the idea that the Fed and other central banks will do “whatever it takes” to support the economy, backstop the financial system, and inflate asset prices. This could end badly unless the new Fed Chair and her colleagues keep their finger on the pulse of the financial markets and are willing to change course quickly, when needed.
–Robert Andriano is the Chief Investment Manager at Pure Investment Advisers, a boutique wealth management firm. For more info visit www.pureinv.com
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