After the last crisis, the Fed pegged the interest rate for one-day maturity at near zero. Throughout its various rounds of Quantitative Easing, most critics expected rising, if not skyrocketing, consumer prices. And the commonly-accepted remedy is for the Fed to raise interest rates. So in Dec 2015—exactly seven years after it pegged it at zero—the Fed began to hike the rate. Over a period of three years and a month, it pushed the Fed Funds Rate up to 2.4%.
We could talk about “yield curve inversion” (i.e. when the short-term rate is above the long-term rate, which causes the banks to lose money) and other technical topics. But instead let’s ask a rhetorical question.
Look at all the business activity that was financed at rates near zero (of course, even the biggest business pays a spread above the government rate). Oil producers borrowed enormous sums to extract oil from shale rock. Even in towns where retail malls were overbuilt (e.g. Scottsdale, Arizona), big developers have been borrowing to build more. Airlines borrowed to buy new planes. Auto manufacturers borrowed to offer 0% financing as a subsidy to consumers. Corporations borrowed to buy their own shares.
All of this borrowing adds to GDP, though not linearly, as borrowing to buy shares does not, itself, add to GDP. The boost comes from the so-called wealth effect, that shareholders feel free to buy a bottle of champagne or a private jet. And the beverage and airplane companies borrowed to add the capacity to serve this demand.
How much of this borrowing would have occurred at higher rates? Much of it would not have been viable. Profit margins are thin, and return on capital is at a record low.
So, we had the Fed looking at the imaginary threats of inflation and overheating, while the self-fulfilling prophecy of rising GDP confirms that the economy was strong. The Fed did what it was it was supposed to do. Keynesians, Monetarists, and otherwise-free-marketers all agreed. So it hiked interest rates.
All during this time (and long before), we were saying that the long-term interest rate trend is necessarily downward. Our assessment that little borrowing is feasible at higher rates helps lead us to this conclusion. Demand for credit would dry up. Even if the Fed did not care about that, and the resulting drop in GDP, there would be a crisis soon enough.
This is because corporations have been trained to borrow using short-term instruments. That’s the strategy for a falling-interest-rates environment. But it does have the drawback that they have to roll their debts every few years. That is, the old bond is due and they must sell a new one to repay the old one. If they have thin margins, and the new rate is higher, they may be in trouble.
So, January a year ago was the last rate hike. The Fed managed to hold the line for six whole months. And in August, they declared the first rate cut. By November, the rate was down almost 1% from the temporary little high of January through July (and another 0.5% in early March).
UPDATE AS THIS ARTICLE NEARS PRESS TIME, THE FED JUST ANNOUNCED ANOTHER 100BPS CUT ON A SUNDAY.
Lest anyone tell you that the economic problem revealed by this episode is entirely due to the coronavirus, we chronicle the abrupt reversal of Fed policy beginning long before said virus.
Contrary to the strong economy belief, the economy has long depended on adding more and more debt. This is not just for growth. It is about staving off insolvency at far too many major corporations, not to mention businesses large and small.
It gives us no pleasure to say now, “We were right.” Watching the epic collapse in the 10-year Treasury yield this week was scary.
In the middle of January, this yield was over 1.8%. A month later, it was still over 1.56%, which is a big drop but nothing compared to what was to come soon after. By the end of February, the rate was just over 1.1%.
Then, between March 4 and March 9, the yield fell from just over 1% to just over 0.5%. The rate was halved. And halved again.
Back to the rising bond price. Does this market move put to bed, finally, the fears of skyrocketing inflation, skyrocketing interest rates, bond vigilantes, and repudiation of the dollar as world reserve currency?
We write often of the capital gains of the speculators. To put this in perspective, over that same time of mid-January through March 9, the 10-year Treasury bond went from about 157 to about 185, or +18%.
Buying Treasurys when the rate was around 3% a few years ago was the obvious play. They’d pay you a lot of interest (as it must be considered in this environment) while you waited for big capital gains. But the question, as always, whither from here?
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The case is not so compelling any more. They don’t pay much interest, any more, and the capital gain is not likely to be so big right after this big move.
Everyone else will be asking this question too. Whither from here? They will be pondering where to put capital.
Now we get to the exciting part. The stock market is where the action is. On February 19, the S&P closed at 3,387 (futures). On Thursday, it closed at 2,469, or -27%. Friday was up a staggering 8.7%.
Most astute commentators believe this rip-your-face-off-rally is due to short covering and other ephemeral technical conditions. Massive spikes are a feature of bear markets, not bull markets.
No doubt, the governments of the world are taking actions in response to the coronavirus that are economically damaging. But we insist that the virus is not the cause of the downturn, though it may be the catalyst.
Airlines, obviously, will suffer big losses due to Trump’s ban on travel to America from Europe. And hotels. No doubt, Broadway theaters and production companies will suffer losses from New York Mayor De Blasio’s ban on large gatherings. And many restaurants and bars in Ohio will close their doors permanently, as a result of Governor De Wine’s order for them to close temporarily.
But we cannot overemphasize that during the 11 years following the last crisis, the root cause was never addressed. Instead, monetary policy was imposed to mask it and enable more of what caused that crisis in the first place.
Unproductive debt.
For example, Boeing bought back $43 billion worth of its own shares. Put yourself in the shoes of the CFO. Suppose you could borrow for less than the cost of your dividend yield, e.g. borrow at 2% and buy shares yielding 3%. What would you do? Especially if most of your personal compensation came from a rising share price.
Boeing recently had two 737MAX airplanes crash. It has been spending cash like crazy to keep airlines happy and to redesign the plane. This was already straining the company. Now the virus has led many governments to impose travel bans. And airlines are not ordering more planes (they’re cancelling orders). This one-two punch may knock Boeing out. We make no predictions, but we can say with certainty that Boeing would be better off now if it had not spent that $43 billion.
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The other 499 companies in the S&P Index may not have committed a multibillion dollar error. They may not be as deeply impacted by the virus. Yet, all of them will see declines in their revenues, and hence shrinkage of already-thin margins and return on capital. Their liabilities, of course, do not go down. And their interest expense may go up when they are forced to roll over their bonds.
If they can roll them. If the market does not seize up, as it did in 2008.
And this brings us to the next factor, and the last section of Part One of this two-part Report.
