First Things First—Where the Trump Administration Left Us
Even acknowledging the effects of Covid-19 on the economy, the Trump administration’s economic record is quite remarkable.
- The largest post-war deficits since WW II. This was going to be the case even before the Covid crisis.
- The three largest trade deficits ever, exceeding $800 billion. The deficit with China was three times higher than the next largest country. This was despite Trump’s argument that winning trade wars was “easy”. His tariffs cost US consumers billions.
- Farmers received bailouts of around $46 billion. The previous record was $10 billion. In fact, two-thirds of farm income last year was payments from the government. This was intended to compensate for his disastrous tariffs and subsequent retaliation.
- The only post-war president to leave office with fewer jobs in the economy than when he started. From Trump’s inauguration to Biden’s, the loss in jobs was 3 million.
Background—Market Interest Rates Do Not Really Exist
The average person has no idea how interest rates can be near zero percent. Home buyers happily buy up properties, taking out mortgages with rates below 3%. For comparison purposes, my first mortgage in 1979 was 10%. Car loans are offered with “0%” financing. How is this possible? Despite unprecedented borrowing needs by the US Treasury to fund the deficits, 10-year Treasury notes pay about 1% interest. If you bought a 10-year note, you would earn all of $100 on a $10,000 investment, hardly a return that will enhance anyone’s investment portfolio.
For the sake of argument, the inflation rate has been around 2% for several years. This means that the interest rate on the 10-year Treasury note is on a “real basis” (adjusted for inflations) NEGATIVE 1%. If you buy a 1-year Treasury bill, you are rewarded with 0.10%, or $10 for a $10,000 investment. After inflation, you actually “lost” $9.90.
How can this exist? Why would anyone buy Treasury bills, notes, or bonds? What is going on has never been done before on this scale. Furthermore, the European Union is doing basically the same thing in the Euro market. What are the implications of this?
How did this happen?
The answer to this is relatively straightforward. The Federal Reserve has the ability to move interest rates. Traditionally, this has meant short-term interest rates, securities with a maturity less than 2-years. They accomplish this by purchasing and selling short-term Treasuries, thereby increasing or lowering short term rates.
During the financial crisis this activity was taken to a much higher level. It is important to understand that the entire world-wide financial system depends on leverage –> borrowed money. If lenders, even on a short-term basis, believe that it is risky to extend credit, then the system breaks down. No one will lend to anyone without pristine credit. This extends from governments to the private sector. When the financial crisis hit in 2008, this trust, willingness to lend, collapsed. Financial markets accordingly collapsed. Economic chaos would have ensued, it actually did, but the Fed and the European and Japanese Central Banks poured money into the system and effectively guaranteed it. Interest rates on short-term bills went negative in absolute terms.
Before the Covid crisis slammed the economy, Trump was lobbying hard for the Fed to continually lower interest rates, basically to zero. The economy was continuing to grow, but that made no difference. Despite being “independent” of political influences, the Fed complied. Trump got his economy (albeit little different than Obama’s economic record) with a historically low unemployment rate. The cost was artificially low interest rates and a rapidly growing federal budget deficit due to Trump’s tax cuts.
Very few people realize this, but when the Covid crisis hit last March, the financial system almost collapsed again. However, the Fed and the European bank provided vast sums of money to ensure that the system continued to function. In other words, they again backstopped the financial markets meaning that they took the risk out of it.
However, during the 2008 crisis the banks not only provided short-term liquidity, but they also drove down intermediate and long-term interest rates by purchasing Treasury notes and bonds as well as highly rated mortgage-backed securities. So both short-term and long-term interest rates declined.
With Trump’s badgering and the Covid crisis, the Fed was put into the same position as 2008, and they responded the same way. In addition to Treasuries and MBS, they expanded their purchases to corporate bonds. Therefore, the Fed has artificially lowered interest rates across the board. Home mortgage rates are at historical lows, and other forms of credit such as car loans and corporate borrowing are as well.
How Did the Fed Accomplish This?
So, how can the Fed and European central bank drive down both short and long-term interest rates and keep them there for an extended period of time, even at “negative” real interest rates? The answer is quite complex, but it basically comes down to this.
THEY PRINT MONEY!
Again, this is very simplistic, but the Fed and the European central bank essentially increase the money supply and buy the Treasury/Euro securities. These purchases increase the demand for the securities, which increases their price, and this lowers interest rates. In other words, the price and interest rate on fixed income securities like bonds are inversely related—the price goes up and the interest rate goes down. Of course, this has resulted in a massive Fed portfolio of fixed income securities.
This activity emerged during the 2008 financial crisis, and it was reimplemented even more vigorously in the current financial/economic crisis. It is important to recognize that the Fed prevented a lot of pain by their actions last year. We were in melt-down mode. It was necessary.
Most people are not even aware of how vulnerable the financial system was last year.
How Long Can This Go On?
The simplistic answer to this is “a long time.” As long as domestic and international investors consider US Treasury securities to be essentially risk-free, they will buy them. There is nothing to stop the Fed from continuing its purchases. Given current and projected budget deficits, there will certainly be a continued issuance surge in Treasury securities. That has no signs whatsoever of abating.
The argument is that we should borrow for household income support and infrastructure programs while interest rates are very low. This makes sense. However, interest rates are ultimately going to rise, and when this massive US government borrowing has to be “rolled over” (refinanced), it will take a substantial and increasing portion of tax revenues. It was not that long ago that interest rates were 2-4% higher. Interest payments at these rates would be extremely problematic for the federal budget.
Given the state of the US and world-wide economies, there is little argument against current deficit financing continuing into the foreseeable future. When this reverses, it could get very ugly in both the stock and bond markets. Unfortunately, the Fed will no longer have the ability to manipulate these markets. Forewarned is forearmed.
Who Is Winning Now and How Things May Change?
This is very simple. Anyone dependent on bonds, CDs, or other fixed income securities are earning virtually nothing. Through direct intervention, the Fed has deliberately forced interest rates to near zero. For those retirees who are risk averse and wanted to avoid the volatility of the stock market, this period has been a disaster. Last year, the economy declined more than anytime since WW II. It can be argued that interest rates near zero prevented a worse decline. Certainly, the housing market has remained strong with mortgage rates at historic lows. Despite the declining economy, particularly for lower- and middle-income households, the stock market rose in double digits. For most investors, the stock market was the only place to go. If one did not panic in March, the rewards were substantial.
What will cause the stock market party to end? For guidance, look to the tech bubble/bust in 2001. For virtually any tech company with a story, investors piled in. The bubble became self-fulfilling. Everyone was claiming double-digit gains on a monthly basis. To those on the sidelines, it was very hard not to join the crowd. My own circumstances were somewhat indicative. I owned a lot of bonds earning 4%. I bought tech stocks that were deemed to be “less risky”, the Microsofts and IBMs of the world. Whereas many of the “hot” stocks went belly up, I still had to absorb significant losses. It made me reluctant to invest back into the market, and that reticence cost me a lot of money during the subsequent long-term rally.
A similar process is occurring now. Just look at the craziness of GameStop trading. Some hedge funds took a beating, but you can be sure that many small investors will get burned. In effect, it is just a Ponzi scheme. You are hoping that someone is willing to pay more for the stock than what you paid for it. When prices start to decline, then everyone wants to hit the exits at the same time. The bubble bursts. It is not just the recent volatility engendered by Reddit. There have been numerous IPOs of companies with negative earnings. Hello Uber. The prospects for many recent IPOs are just fantasy. Ultimately, what will really break the market is a rise in interest rates. In my opinion that period will be very ugly. Then the obvious question is, when will that happen? What is one supposed to do in the interim?
Unfortunately, I am not clairvoyant, and I have learned the hard way not to try to time the market. The Fed has signaled that it will keep interest rates low through next year, and that it would like to see higher inflation. In my opinion higher inflation will be the signal to reduce exposure to the stock market because that will ultimately lead to higher (much higher?) interest rates. Remember that adjusted for inflation, current interest rates are negative. If they became more negative and the extreme Treasury financing needs undoubtedly continue, higher interest rates are ultimately assured. This will knock the legs out of the stock market. Let us be real. The only reason the stock market is so high is because market interest rates do not exist. That cannot last forever. As one observer noted, it has been socialism for the rich and capitalism for the rest. By avoiding an economic collapse, the Fed has simply made the rich wealthier. This is yet another example of “unintended” consequences of economic policy.