26 Feb AN UGLY DAY INDUCED BY PLUNGING BOND PRICES
Rapidly rising interest rates are weighing upon the markets. There are many causes for this rise but perhaps the two widely accepted reasons are the incessant demand for monies by the government as policy makers begin experimenting with MMT (Modern Monetary Theory) and the rising inflationary expectations because of such policy.
MMT is a belief that a country can print, spend, tax and borrow in a fiat currency that they fully control and the country is not operationally constrained by revenues when it comes to federal government spending.
Put simply, such governments do not rely on taxes or borrowing for spending since they can print as much they need and are monopoly issuers of their currency. Since budgets are not like a regular household their policy should not be shaped by fears of rising national debt.
The last experimentation with MMT in an industrialized country ended disastrously via hyperinflation. It was a major reason for the rise of Hitler. There is a litany of lesser developed countries that experimented with MMT, all of which also ended in cataclysmic failures.
Few market participants have experienced the horrific impact of inflation for as noted the other day the 2-year Treasury, the instrument most sensitive to monetary policy, peaked at 16.25% in August 1981. The two year today is around a record low yield of 0.12%.
There is considerable discussion as to how much the advance in the market over the past four years is the result of PE expansion…aka declining interest rates versus earnings growth. By definition lower interest rates dictate higher valuations and vice versa. Rising interest rates and falling earnings is the proverbial death cross for the markets.
Economic and fiscal policy matter. Historically the markets perform better under a democratic administration given their propensity to spend more money. However, at some juncture the sand pile will topple.
Government is expected to create economic policy that is conducive to growth not to create the growth itself. There is near unanimous decision government is the worst steward of money as the profit motive is absent. It is someone else’s money.
It is widely accepted the Biden Administration is increasing the bureaucratic and regulatory state by the greatest proportion since LBJ’s New Deal that was paid via deficit spending.
To write it differently, the Biden Administration is proposing giving more people a fish paid for by borrowed money versus creating polices to teach a person to fish and policies conducive to creating a better fishing pole.
It is highly unlikely the equity or debt markets will repeat the performance under the Trump Administration. The accepted Treasury benchmarks—defined as the 2, 10 and 30 year Treasury–declined from 0.819%, 1.82% and 2.88% to 0.149%, 0.81% and 1.66%, respectively.
As noted above, the primary determinate of equity valuations are interest rates. Such a decline in rates permitted higher valuations for the indices. [Note: There was a near unanimous agreement that the indices were/are not overvalued in January because of current interest rates.]
According to Bloomberg, during the Trump Administration, annually the NASDAQ, S & P and the Dow returned about 23%, 13.5% and 12%, respectively, partially the result of a decline in interest rates. These returns are considerably higher than long term averages.
As written, regulation and bureaucratic intrusion impacts growth. Even with the greatest economic contraction in history, the US economy expanded at a 2.0% annual rate under the Trump Administration, slightly higher than the average since 2004 partially the result of easing regulation and taxes.
As written several times, the Treasury market is getting crushed, the worst start of a year since at least 2013, primary the result of fiscal and economic policy that is creating both demand pull (product) and cost push (wage) inflation. The yield curve is the steepest in at least eight years.
The CBO projects if a major tenant of the passed $1.9 trillion stimulus is enacted—the increase in minimum wage to $15—1.4 million jobs would be lost and inflation will rise to 4.0% because of rising wages. The International Energy Agency projects a gallon of gas could reach $4.50/gallon under Biden’s energy policy.
Recently equity volatility has increased, primary the result of rising interest rates. Oil has surged.
No one knows the future. However, if economics is indeed a science, and if science is followed, interest rates and inflation have a strong probability of being considerably higher tomorrow, equity volatility substantially increase and real GDP growth greatly challenged.
It was widely expected the current Administration would govern from the center. Instead it is perhaps the most progressive Administration in history. Economic, fiscal, tax and regulatory policy impact all segments of society.
What are the odds that in 9-12 months all will be wishing for a different Administration more akin to the previous one absent the tweets and the obnoxiousness?
If history is a guide and if we follow the science, the odds could be high.
Enough of the rant, equity markets sold off significantly because of surging interest rates. The tech heavy NASDAQ which is more prone to higher interest rates declined about 3.75%. The Dow off about 1.75%. The 10- and 30-year Treasury sold off about 1 ½ and 2 ½ points respectively.
Last night the foreign markets were down. London was down 1.43%, Paris down 0.87% and Frankfurt down 0.48%. China was down 2.12%, Japan down 3.99% and Hang Seng down 3.64%.
The Dow should open choppy as futures are fluctuating between nominal gains and losses. The 10-year is up 17/32 to yield 1.47%.