INVESTMENT SOLUTIONS THAT FIT TODAY’S GLOBAL ECONOMY
Making Sense of Interest Rates
January 2014 • Volume 3, Issue 1
By W. Michael Cox and Richard Alm Small Talk What a year for investors! The Dow Jones Industrial Average and S&P 500 both soared by more than 26 • Movin’ on up. With a new year, the meter
percent in 2013, ending the year at record highs. The of annual income resets to zero—so everyone’s equal for a few seconds. Then the NASDAQ index did even better—a 38 percent gain. race begins again. In December, the Internal The Federal Reserve’s low interest rates provided Revenue Service released new data, covering most of the fuel for the stock market’s joy ride. 2011, that suggest it will take something During the year, the raging bulls shrugged off a like $120,136 to make the top 10 percent so-so economy, Washington’s budget battles and of income earners. The top 5 percent starts at $167,728. Both are record highs. The warnings of a stock market bubble. Just about the only cutoff for the top 1 percent is $388,905, persistent downer was the anxiety over whether higher down from a peak of $426,439 in 2007. interest rates would spoil the fun. As stock indexes Making it into the most exclusive club—the inexorably climbed, investors couldn’t shake the worry top 0.1 percent—takes at least $1,717,675, that the Federal Reserve would tap the brakes by or quite a bit less than the $2,251,675 in 2007. tapering off on its money-creating bond purchases. • Infinite tax rates. The tax on long-term The Fed, however, kept the pedal to the metal until capital gains rose from 15 percent to 23.8 mid-December. Only then did it take a first tentative percent a year ago. The Tax Foundation’s step toward tapering off its money-creating bond Kyle Pomerleau says the burden will be purchases, announcing it would pare the program higher for shares bought in the past and sold in 2013. The analysis starts with the from $85 billion to $75 billion a month. average return on the S&P 500, then takes The decision didn’t represent much of a change in inflation into account. Pomerleau calculates the Fed’s mind-set. The taper’s small size suggests the real effective tax rate, finding it exceeds the central bank doesn’t really believe the economy the statutory rate for stocks bought in every can stand on its own. The policy keeps interest rates year since 1950, sometimes by a lot. For most years, the real effective rate was low and continues to flood the economy with new between 26 percent and 38 percent. The average from 1950 to 2012 was 42.5 Interest Rates: Still Low But Starting percent. Low returns and inflation created some shocking outliers—309 percent for 20% 1998, 286 percent for 2001, 93 percent for 2004. Most shocking of all, negative real 18% returns made the effective tax rate infinite for stocks bought in 1999, 2000 and 2007. •
Deeper in debt. President Obama’s supporters are trying to cast him as a champion deficit cutter, pointing to the reduction of the federal red ink from $1.4 trillion in 2009 to $972 billion in 2013. The rest of the story: The national debt has risen from $10.7 trillion when Obama took office to $17.7 trillion at the end of 2013— so 40 percent of the nation’s debt came on this president’s watch. And he’s not done yet. Projected deficits over the next three years will total more than $1.8 trillion.
money. So in 2014, investors will remain fixated on when interest rates will rise and by how much. Financial markets provide some clues. Looking at today’s interest rates tells us something about what investors think will happen to future interest rates—not just over the next few months but far beyond. Assessments will change as markets move forward and incorporate new information; however, the start of this year is a crucial time for investors to take stock of interest rates. Rates drifting up Markets set interest rates on a wide array of borrowing and lending—mortgages, corporate bonds, government debt, business loans, credit cards and new cars, to name just a few. For simplicity, we’ll focus on the federal funds rate, set by the Fed, and the interest rates the U.S. Treasury pays on its bills, notes and bonds, the assets with the lowest risk. In recent years, these interest rates have sunk to historical lows (see chart below ). At the top, 30-year Treasury bonds have started to push toward 4 percent. At the bottom, the fed funds rate and three-month Treasury bill are still scraping along just above zero. In between are issues of other maturities, lining up in descending order from longer to shorter. Continued on page 2
to Bounce Back at the Long End Yield Curves 4.0% 3.5%
December 5, 2013
May 2, 2013
Interest Rates on Treasury Debt
12 14 16 18 Years to Maturity
8% 30 Year 20 Year 10 Year 7 Year 5 Year 3 Year 2 Year 1 Year 3 Month Fed Funds
Fed Watch and Chart Topper: Page 3 4% 2% 0% 1977
Source: U.S. Treasury
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Continued from page 1
The pattern is typical. Longer-term commitments carry greater risk of unanticipated events, either individual or economy-wide, that affect borrowers’ ability to repay. In addition, the longer rates include a premium for expected inflation, a compensation for the erosion of the dollar’s buying power. A cross-section of rates at various maturities gives us the time structure of interest rates—the yield curve, familiar to most investors. In early May, with the economy wobbling and the Fed buying securities, long rates were depressed, and the yield curve topped out at 2.82 percent (see inset chart ). By December, long rates were on the rise, creating a steeper yield curve, with the 30-year Treasury at 3.92 percent. From there to the end of the year, the yield curve stayed relatively unchanged. Short rates stayed at rock bottom, while the 30-year Treasury ended December at 3.96 percent. Forward interest rates Gaps of up to five years in Treasury maturities affect the shape—and the meaning—of conventional yield curves. We created a more precise measure that will give investors better information on what interest rates are telling us. It rests on a pure term structure theory of interest rates, which assumes that markets keep rates at levels where lenders are indifferent between holding securities of various maturities. Simply put, all arbitrage opportunities have been exhausted. We then infer forward interest rates at one-year intervals—all the way out to 30 years. The results for early December suggest investors expect interest rates to remain very low in the near
term—just over a tenth of a percent at one year out (see chart below ). Then there’s a sharp spike, and interest rates rise to 4.4 percent at the seventh year. After that, they level out through the 30-year mark. May’s rate structure was lower, with a kink upward starting at the 20-year mark. How does this compare to the conventional view? Interest rates don’t begin to increase any sooner—but, once they start upward, they rise faster and farther. Investors expect the Fed to maintain current policies for the next year or so, suggesting any tapering off of the central bank’s bond buying will be gradual. Inflation will stay exceptionally low, most likely because a sluggish economy will limit pricing power in the short term. After that, sentiment shifts markedly. The quick runup in interest rates suggest that investors have little confidence that the Fed can continue to keep a lid on inflation. So they’re demanding sharply higher interest rates three to five years out. In 2013, we saw how the interest rate structure shifted upward from May to December. Markets will adjust as investors see how the economy and Fed perform in the new year, with additional upward movement in forward interest rates a real possibility. A final thought. Take another look at the chart showing Treasury interest rates. In a few places, shortterm rates pop up above long-term ones—most recently in 2006-07 and, before that, in 2000-01. It’s more a matter of short-term rates rising than long ones falling. The Fed, concerned about inflation, raises the federal funds rate, which dampens economic activity. Inverted yield curves are signs of pending recessions.
What It Means for Your Clients For most of 2013, your clients heard financial gurus predict that interest rates would be going up. The warnings were dire: investors would end up poorer as rising interest rates drove down the prices for stock and bonds. Interest rates rose less than expected, and stocks surged upward, largely because the Fed decided against backing off on its stimulus. If nothing else, your clients should now understand the difficulty of forecasting interest rates, particularly in these uncertain times. Still, we need to try—they’re too important to ignore. Investors should arm themselves with factual information, rather than relying on market chatter. Dr. Cox’s analysis makes use of the term structure of interest rates, based the actual market decisions of millions of investors in Treasury securities. For interest rates, the question isn’t what direction; it’s how fast and how far. Dr. Cox shows that interest rates started inching upward during the year—and signs point to further increases in 2014.
What the Markets Say—Implied One-Year Forward Interest Rates 4.5%
December 5, 2013
However, the data suggests the threat of a sudden jump in interest rates seems remote. Investors will probably want to make changes in investment strategy as interest
rates move upward. But they will have
3.5% May 2, 2013 3.0%
time. Getting too worried about rising interest rates and pulling the trigger too
Interest rate projections based on pure term structure theory of interest rates
soon could cost them money—certainly that was true in 2013. Dr. Cox wisely cautions that the
message in the Treasury rates will change
with new information on the economy and Fed policy. Your clients should pay close
attention and be ready to act when the
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Years in the Future Source: U.S. Treasury, authors’ calculations
time’s right. By Argentus Partners, LLC
About Michael Cox
W. Michael Cox is director of the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business. He is chief economic advisor to Argentus Partners, LLC.
Richard Alm is writer in residence at the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business
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W. Michael Cox’s Fed Watch: Transitions at the Federal Reserve Board are rare. A new chairman has taken over just six times since 1951. By comparison, a new president has moved into the White House 12 times in those 60-plus years. Only once has monetary policy changed radically— when Paul Volcker replaced G. William Miller in August 1979. Inflation had surged in Miller’s brief tenure, going from 6.6 percent in March 1978 to 11.6 percent the month he stepped down. Volcker’s mandate was to tame inflation. Under his leadership, the Fed siphoned off the excess money that had fed the rise in prices; interest rates spiked and the economy tanked, not once but twice. By 1983, Volcker’s Fed had inflation down to 3.2 percent. Other Fed transitions were far less eventful, particularly in recent decades as Alan Greenspan
replaced Volcker in 1987 and Ben Bernanke replaced Greenspan in 2006. For the most part, the face changed but policies didn’t—at least not by much. This thumbnail of Fed history is relevant now because Janet Yellen, a Fed insider, takes the central bank’s helm at the end of this month. She inherits Bernanke’s mandate as well as his title—first and foremost, do whatever it takes to bring down an unemployment rate that’s still too high. I’m not going to judge Yellen on those terms. My research tells me that unemployment doesn’t respond to Fed stimulus, and the past five years have only reinforced my judgment. The most expansionary monetary policy in history has yielded a pace of job creation so slow that we’ll never return to the full employment conditions of 2007.
For me, Yellen will succeed as chairman if she returns the Fed to normalcy. For five years now, the Fed has been living on the edge, conducting monetary policy in crisis mode. This can’t go on. What’s normalcy? It means easing the danger of a burst of inflation by reducing the bloat in the central bank’s balance sheet. It means letting interest rates return to their historical norms. It means getting the economy off the drug of stimulus and allowing the private sector to drive growth, employment and investing. In 25 years at the Federal Reserve Bank of Dallas, Dr. Cox rose to chief economist and senior vice president, advising the bank’s president on monetary policy and other economic issues.
Chart Topper Homeowners Rebuilding Equity—But They Still Have Long, Long Way to Go A double whammy hit the nation’s housing wealth over the past seven years. Inflation-adjusted equity per home-owning household declined at the same time as the homeownership rate. In 2006, an average home equity peaked at $202,278. Households spent a big chunk of their equity just trying to hang on during the financial crisis and recession, driving equity down to $85,433 in 2009. As the economy and stock market began to recover, the housing continued in the doldrums, and equity bottomed out at $81,663 at the end of 2011. During the hard times in housing, the home ownership rate declined from 69 percent to 65 percent of households. Home prices have begun to recover recently, but households’ real estate wealth remains depressed. After accounting for overall inflation, homeowners now have an average of $120,135 in equity, or 40 percent less than in 2006. The Federal Reserve conducted its detailed survey of household wealth in 2013. When released later this year, the data will provide additional information on American homeowners’ debt and equity.
Home Ownership Rate
$120,000 Inflation-Adjusted Real Estate Equity Per Home-Owning Household
Source: Federal Housing Authority
About The Argentus Outlook A monthly publication of Argentus Partners, LLC, the newsletter strives to deliver current economic information relevant to investing and operating in today’s complex global economy.
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Important Disclosures: Information herein in this newsletter and has been obtained from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. This newsletter is for informational purposes only, and should not be considered as an offer, invitation or solicitation to subscribe, purchase or sell or any securities, and is not intended to provide any specific investment advice or recommendation. You should review your personal financial situation, investment objectives, goals and risk tolerance prior to investing. All indices referenced are unmanaged and an investor cannot invest directly into any index. The economic forecasts and projections illustrated in the newsletter may not develop as predicted and there can be no guarantee or assurance that strategies promoted will be successful. All expressions of opinion reflect the judgment of Dr. Cox and his research conducted for Argentus Partners, LLC at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. This research material has been prepared by Argentus Partners, LLC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that Argentus Partners, LLC is not an affiliate of and makes no representation with respect to such entity.