As the eight year old bull on Wall Street is slaughtered for its meat, several questions come to mind. Is the fall likely to continue? Where will it stop? And, for those on the sidelines looking to score political points, who is to blame?
The answers to these questions are easy and a little terrifying. Yes, this is going to go on for a while. It may not stop until a lot of money is lost. And while you can’t blame anyone for actions which are cyclical, you can blame those who make things worse. The US economy is a large engine, and any good mechanic knows that while you can do a few small, smart things to make it run better it is much easier to really screw it up.
We need to start with what is happening. Amid record corporate profits and a labor market so tight that wages are rising, there is a lot of trouble. Interest rates are rising, meaning that money is not going to be as cheap as it has been over the eight years of rising stocks.
Ten year treasuries are currently yielding over 2.8% interest. That’s a large jump from the bottom of 1.4% set in June 2016. It means that money for expansion of businesses, new homes, and all the things which expand the economy is already much more expensive than it was just a short time ago.
And we can be sure that it’s only going to get more expensive from here.
There are three significant forces which will drive up interest rates and thus put a damper on stocks. They are Federal Reserve policy based on a need to control inflation, a lack of foreign money coming into our markets, and finally a massive increase in federal deficit spending coming at exactly the wrong time. Let’s look at each of these one at a time.
The Fed Funds Rate is Going Up
The Federal Reserve Open Market Committee meets eight times a year to consider interest rates. In 2017, the rise was slow and capped out at 1.5%. We have every reason to believe that this will accelerate. A quarter point per meeting, or an additional 2% this year to bring it to 3.5%, is far from out of the question.
We can estimate where the Fed Funds rate should be based on an equation from economist Greg Mankiw. It’s been at least close before 2010, when it went negative:
As you can see, rates should be around 5.2% now, based on historical action by the Fed. The net gap between where we are and where we are likely to be soon is massive, larger than it ever has been. The Fed is likely to race to catch up quickly.
We can be sure of this because the 2% target rate of inflation has been breached already. This is caused by the same rise in worker’s salaries and the net inflows of money into the US, which we can talk about more. But what matters is that inflation is indeed taking off:
Will the Fed Funds Rate hit 3.5% this year? It probably should. The last time Wall Street saw a regime of rising interest rates was over 20 years ago. Most of the traders on the floor now do not remember it. The mantra is always “Don’t Fight the Fed” in situations like this. Do they know that?
Foreign Money is Staying Home
As Barataria has discussed before, what fueled the dramatic drop in benchmark ten year treasuries, and corresponding drop in interest rates for businesses and consumers, was foreign money. Lots of it. Much of it came from China, but with Europe looking moribund the money came from everywhere. It was looking for a safe harbor, a place to sit, and nothing is safer than treasuries.
How much money? A total of $2 trillion came in from China alone between 2014-2017. Not all of that went into treasuries, but a lot certainly did. With a total publicly traded debt of $13.6 trillion there is no doubt that foreign money, peaking at the end of 2015, had a lot to do with the dramatic fall in interest rates.
With fixed dollar payouts every month, the interest rate for treasuries is essentially set by the market price. The net interest rate equals the interest payment over the value of the bond. Greater demand for bonds means the value goes up, so the rate goes down. Lower demand for bonds makes the rate go up.
China has stopped the bleeding of cash which fueled the dramatic rise in bonds and corresponding drop in net interest rates. Without that downward pressure, where would ten year treasuries have been as the Federal Reserve started raising interest rates? We’re about to find out – and then some.
The Deficit is Jumping – Bigtime
The Federal deficit, or net need to sell treasuries, is about to rise. It was at $519 billion per year, but is expected to be $955 billion this year. The reason is a simple one – the large tax cut passed in December.
The net rise of over $400 billion in net sales was last seen in 2008, when the economy tanked. That time, however, was different, as the Fed Funds Rate was going down and ultimately set to zero. We have not seen a large increase in deficit spending at a time of rising rates for nearly 40 years, and that was catastrophic.
In October 1981, the 10yr treasury peaked at over 15%, a rate unimaginable today. It was also a period of high inflation and the Fed was determined to put a stop to it. We aren’t likely to see rates that high, given the long-term trend towards cheaper money and a much greater openness to money flows around the world.
But we can expect only more downward pressure on treasuries and even more downward pressure on stocks.
We will not know the full effect of this for over a year, but the stock market is very likely to respond through the summer. Constantly rising interest rates will start to put a damper on everything. Corporate profits may be up, but much of the rise in corporate investment has come from borrowing. That will not continue in this new regime.
Where We Go From Here
There is no doubt that the stock market is falling for some very good reasons, and will continue to fall. Where will it land? We can’t say yet. That takes some more analysis and a few guesses as to sentiment.
We can’t underestimate the simple reality that today’s traders do not remember the last time interest rates rose dramatically or indeed the especially harsh period of the early 1980s. This will take some time to sink in, so dramatic one-day falls are only the start.
The long and short of it is that we should be prepared for a period of inflation and falling stocks. In the short term, sitting on cash looks like the way to go, but in the longer term a hedge against inflation is going to be critical. That market is simply not well defined.
Right now there is only one thing for sure – the stock market has to fall. It’s a matter of how much and how fast.