The Rate Cuts Are Coming, but Economic Growth Isn't

The Rate Cuts Are Coming, but Economic Growth Isn't
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It’s weird that the White House projections for the federal budget are much rosier than those from the other parts of the government. The Executive branch, after all, isn’t responsible for spending and taxes. It’s Congress and specifically the House where all budget activities legally originate. If anyone is going to have to sell a long run plan, it should be one or most of those Congressmen rather than the President.

According to the latest fiscal projections from the Executive, though, everything is going to work out just fine and dandy. Though the federal government’s reported deficit is going to rise sharply in fiscal year 2019, that’s just the short run price of tax reform. Over time, these forecasts say, that money will more than pay for itself in a boost to growth.

The White House believes the deficit for the current year (ending September 30) will be $1.09 trillion. In fiscal year 2018, it was $779 billion. During Bush 43’s first term, just one year’s budget shortfall of around $250 billion was cause for widespread apoplexy. Nowadays, an increase of a quarter trillion from one year to the next isn’t too far out of the norm.

Despite this, for its 10-year budget window at the far end in FY 2029 its statisticians have calculated a budget deficit of just $202 billion. The reason? Receipts are projected to grow from $3.4 trillion to nearly $6.3 trillion. Total on-budget outlays will only increase from $4.5 trillion to $6.5 trillion.

It is the very definition of the best-case scenario. Even if you think tax proceeds will rise that fast, holding responsible on spending?

The Congressional Budget Office, however, isn’t so sanguine. Its projections using slightly different methodology shows a 2019 deficit of $896 billion. This grows to more than $1.4 trillion in ten years’ time. In other words, a couple more years close to $1 trillion and then eight straight above that level escalating the entire time.

This will require debt purchased and held by the public to increase from the $16.6 trillion currently to more than $28 trillion by the end of the projection window. That’s a ton more federal paper to sell.

And that’s assuming spending and receipt forecasts are close to accurate in all the various entitlements. The CBO doesn’t tally unfunded liabilities here. Even in its long-range estimates, social security, medicare, and the other major healthcare entitlements will together take up more than 17% of GDP by 2040-49. That’s up from around 12.8% today, and this estimated increase might be on the conservative side.

At a time when US government debt supply is going to be rising, demand for it, we are told, is falling. All the big pools are out. The Federal Reserve, for example, has ended its four QE’s, the last of which, QE4, focused entirely on buying US Treasury debt. After purchasing more than $2 trillion, the central bank isn’t even rolling over maturities any longer.

Foreign governments and central banks aren’t buying, either. By count of the Treasury Department’s TIC figures, overseas official holders have sold (net) just about $200 billion specifically UST’s over the last twelve months (through the month March 2019). The Chinese have gone back to “warning” everyone they aren’t happy with their reserve allocations.

Even the big banks keep signaling they are out. Scarcely a day goes by without some bank Economist on Bloomberg echoing Jay Powell and the FOMC. Inflation and economic growth up, as the White House believes, that’s a really bad time to be holding safe assets. If the FOMC projections are right about all that, growth and inflation, then President Trump should have a very hard time convincing anyone to buy debt at prices that don’t become extremely cheap.

This was exactly the message the “bond kings” were selling back in November last year. Jeffrey Gundlach, one of them, said on his widely followed investor webcast how this huge mismatch between supply and demand could only drive interest rates higher and higher.

At the time, the yield on the 10-year UST was nearly 3.20%. Several months earlier, in May 2018, Gundlach had warned to focus instead on the 30-year long bond.  

“I am not that concerned about the 3% yield on the 10-year Treasury. The 3.22% yield on the long bond is a bigger deal. If the 30-year takes out that yield, then the 10-year yield will break out upwards.”

This would, as Gundlach believed, signal how supply and demand were too far imbalanced to keep the three decades of the so-called bond bull going. In his view, this would mean the 10-year reaching 4% as just the first stop.

The 30-year yield did, in fact, breach that level – and then some. When he spoke again in November, the 30s were nearing 3.50%.

Just a few days before Jeffrey Gundlach last May, JP Morgan’s CEO Jamie Dimon was saying much the same thing in the 10s. He warned that Fed was going to become more aggressive to head off the inflation he agreed was looming. As such, Dimon scolded, “You can easily deal with 4% bonds and I think people should be prepared for that.”

However, combined with QT, the Federal Reserve’s balance sheet normalization, as well as much higher fiscal deficits, Dimon was also worried that 4% might prove unrealistically optimistic. Volatility might increase due to so much debt supply, leading to an upward spiral – fewer buyers, more debt to sell, sharply rising interest rates scaring even more buyers away.

By last August, Dimon went even further. “I think rates should be 4% today. You better be prepared to deal with rates 5% or higher — it's a higher probability than most people think.” As head of one of Wall Street’s oldest, most respected banks his words were taken very seriously. In the media.

Interest rates this week are less than they were at any point last year. Compared to when Gundlach and Dimon were predicting how interest rates had nowhere to go but up, they are substantially less. What were they missing?

Inflation, obviously. For one, even the Federal Reserve no longer believes it will be a problem. “Muted” is how pressures were termed back in January and “muted” they still are in May even though the unemployment rate last month fell to the lowest since the 60s.

But that’s not the only thing, or even the main thing. What happened to inflation is very much entangled in everything else, particularly the behavior of bond yields. Dimon’s own bank wasn’t heeding his advice. In its SEC filings, JP Morgan reported a massive increase in UST holdings during the same period when the bank’s CEO was telling the public these assets were increasingly toxic.

At the end of Q1 2018, JPM showed $42.5 billion in UST’s and agency debt listed at fair value. By the end of 2018, the amounts reported at fair value had risen to nearly $60 billion. During Q1 2019, this same institution added another $43.5 billion for a grand total of $102 billion at fair value. Well more than double from the prior year.

Unlike its leader, the bank itself was more worried about something else besides inflation and old-age retirement benefits.

This, by the way, is nothing new. We go through the same pundit cycle every few years. It was fashionable in 2013 and 2014 to talk about the end of the 30-year bond bull market, too.

On May 10, 2013 (May must be a fashionable month for bond calls), another proclaimed bond king this time Bill Gross wrote that, “The secular 30-yr bull market in bonds likely ended 4/29/2013.” The yield on the 30-year long bond the day Gross claimed the bull ended was 2.88%. The yield on the 30-year bond yesterday was 2.75% (and still falling).

The bull never ends.

Supply and demand. Demand is always forecast to run out. Yet, every few years it is proved there is overwhelming demand no matter the supply nor the inflation and recovery forecasts from Jay Powell, Janet Yellen, and Ben Bernanke. There is more than mistrust here.

While bank Economists have constantly gone on TV and filled terabytes upon terabytes of internet stories with their bond bearish views, yields never did move that far (flat curve). And now they are down again. They talk about the bond market, but they are not the bond market. The implications go way beyond questions about the media.

We are left, once more, only with Bill Dudley.

“MR. DUDLEY. Well, another explanation is that the economists who make the dealer forecasts are not the traders who execute the Eurodollar futures positions.”

Or UST positions; whether repo, futures, or whatever other format. What Mr. Dudley was desperately trying to dismiss back in early 2007 was the same things we see today. The bond market is all-encompassing but it doesn’t include Economists; nor, it seems to be, certain bank CEO’s.

It’s weird because this was a serious element to what John Maynard Keynes talked about in The General Theory of Employment, Interest and Money. All the right people are Keynesian nowadays, especially after 2008. Though maybe only the certain parts that advance specific political agendas.

Keynes talked about liquidity preference theory in terms of consumers holding money. You want to keep on hand enough cash to cover the basic expenses (transactions motive). You also probably want to hold back some for emergencies (precautionary motive). To get you to part with money you hold for those two motives requires substantial, huge returns on that money.

The last is the speculative motive. This one is simple, too. If you don’t think there are fat rewards out there in the world, why hold anything but the most liquid forms of currency? Another way of putting it would be to focus on risk; if risks are too great, meaning returns might be potentially high but also highly suspect, you aren’t going to give up liquidity for them, either.

Keynes’ framework here works very well in explaining Milton Friedman’s interest rate fallacy. It was Friedman who famously complained how modern (neo-Keynesian) Economics has interest rates entirely backward. High interest rates don’t mean money is tight in the real economy, as you’ll hear any central banker claim, they signal how money is instead loose. High enough interest rates, as in the Great Inflation seventies, too loose.

In Keynes’ liquidity preferences, then, speculative returns are good enough at high rates to get agents to give up money rather than hold or hoard it.

Transpose these factors onto the global banking system, where money is more fungible and includes a menu of monetary alternates like UST’s and FX, and there is no mystery in bonds. Banks like JPM will cling to the most liquid forms of investment when returns are perceived to be too low or too risky.

The fact that this perception in fact might conflict with the official consensus is no conflict at all. The official position must be wrong (officials have absolutely nothing riding on the outcome, not even their reputations which remain sterling no matter how badly they perform). Global banks, as Bear Stearns taught them, can have their lights turned out in a matter of days.

This relates entirely to the demand for liquidity and therefore liquid investments. Working backward, falling UST yields tell us something very important about the perceived state of global US$ liquidity from the inside. Risks must be rising as interest rates are falling. The cliché “flight to safety” is somewhat appropriate.

But because central bankers, bank managers, Economists, and even bond kings have it all backward, none of them seriously factoring liquidity preferences, the 30-year bond bull keeps surprising them every few years when global monetary problems reappear. Rates are supposed to liftoff, instead they cycle further downward. Both Keynes and Friedman have drawn for us a roadmap to not just what’s wrong but also why.

It only lands in the hands of the blind.  

Let’s go back one more time to Bill Dudley in 2007. When asked what banks might do to mitigate liquidity risks, he replied:

“MR. DUDLEY. One thing to do would be to buy Eurodollar futures or Treasury securities.”

And then he went on to claim how this might create distortions, “at least temporarily, those yields may not fully reflect what the market expectations are.” It was an exercise in self-delusion, the only distortion the twisting of logic to fit preconceived official conclusions (NO RATE CUTS EVER!)

Buying up UST’s and eurodollar futures as liquidity hedging is a false signal to these people. That’s why they never got bonds, or the economy, right. They still don’t.

In other words, they don’t understand the monetary system. Everyone just assumes, central bankers included, it was all fixed in 2009 by a bunch of QE’s and their bank reserves. From this one mistake, all the rest.

There is every fundamental reason in the world to sell UST’s. The long run profile of the issuer, the US federal government, is atrocious and in no way fits with the ability to borrow at better than 3% long run interest rates. The fact that US government securities are being bought hand over fist right now tells you that the reason they are being bought must be beyond compelling and more so one that is very widely shared.

Curve inversions of this nature cannot be a few players worried about something small, it has to be every player worried about the same big thing.

The rate cuts are coming, Jay Powell. Inflation and accelerating growth are not. You don’t know it yet nor will you like it when you eventually propose and vote affirmatively for them, but the cuts (plural) are coming nonetheless. The problem isn’t markets, the problem is Economics. Even those who claim to speak for the former are only doing so as the latter.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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